Market Pressure

03/27/2008 05:44 pm ET | Updated May 25, 2011

How can we explain financial markets? This week, millions of investors are trying to make sense of the past few weeks. Why did bank shares collapse so much? Can any rebound be sustained and what might be around the next corner?

Before we try to answer these questions, it is important to appreciate that we are probably not out of the woods yet. The volatility in markets implies that one piece of bad news can send shares tumbling. On the other hand, a ray of hope is seized upon as a sign that good times are ahead and shares surge. It is clear that now that "no one knows anything, about anything." Traders are caught in the constant crossfire reeling from fear to elation.

Common sense suggests that we are now in a financial phase that could be described as the great unwinding. All over the world, leveraged bets that were placed in the past five or six years are being unwound, and credit is getting not only tighter but in many cases has disappeared altogether. Many people have been terrified by the suddenness and the magnitude of the downturn and are seeking a plausible explanation of the crisis that doesn't involve things we've never heard CDOs, ABSs, monoline insurers or structured products, to name a few.

One interesting and possibly helpful way of looking at the behavior of financial markets is to compare it to geology.

The earth's rigid outer shell, the lithosphere, is broken up into an extraordinary mosaic of oceanic and continental plates. The financial equivalents of the geological mosaics are the many markets which reflect global economic trends such as the stock markets, the commodity markets, housing markets, and foreign exchange markets. In geology, just underneath the lithosphere, there is another layer -- a more fluid, plastic-like surface, called the asthenosphere. This is the uppermost layer of the earth's boiling core, which bubbles away below. Trends in financial markets and global economics such as bank lending, house prices, and immigration create the same pressure as they bubble away under the surface.

Ultimately in geology, when the pressure in the bowels of the earth gets too intense, the core bubbles and occasionally, where the lithosphere is thin or cracked, it explodes via violent volcanoes. We can regard financial deregulation -- which America bought into big-time -- as a process which stretches the economic lithosphere making it susceptible to cracks. Put simply if the banks lend recklessly to people who had no means of paying the money back and then dress up this loan as an asset that can be traded, we know that credibility as well as prudence have been stretched.

When pressure gets too extreme in financial markets, the resulting violent volcanoes can be seen in the banking crises, house price booms and busts, large falls in exchange rates and gyrating stock prices.

Normal day to day market fluctuations are like the daily grinding of the Earth's continental plates. So for example, along the 1,200 km San Andreas Fault, the Pacific Plate has been grinding horizontally past the North American Plate for 10 million years at an average rate of about 5 cm per year (about the same speed as your fingernails grow). There are about 10 other main fault lines across the globe, so earthquakes both on land and under the sea are relatively easy to locate, but predicting precisely when they will happen is almost impossible. The crucial thing is that although we can assess the pressure points, we don't know for sure exactly when and with what intensity the financial markets will erupt.

In times like this, the world is living on a financial San Andreas Fault and everyone is worried that the next tremor will be "the big one."

David McWilliams is author of The Pope's Children (John Wiley and Sons), available now.