An Explanation of the Current Financial Crisis

This past weekend's summit of world leaders in Washington represents another step in the painful process of fixing today's financial crisis. As our leaders go about this formidable task they would be well advised to consider some of the unintended consequences of previous attempts to fix credit crunches, and how some of those 'fixes' inadvertently contributed to today's problems.

The first lesson concerns the dangers of state subsidised lending, a story that goes right back to the Great Depression. Back in the 1930s the American economy was, as it is now, caught in a debt deflation resulting from a failure of the private sector banking system to provide affordable mortgage funding to ordinary American families. One of the fixes for this problem was the establishment of Fannie Mae the state backed agency whose job it was to buy mortgage loans on behalf of the government, thereby providing credit to the moribund housing market. This neat idea is exactly what is needed now to help restart today's mortgage market and is not far removed from the originally proposed TARP plan. Unfortunately however we are not in a position to deploy the Fannie Mae fix. Somehow someone forgot to turn off the subsidy when it was no longer needed and as a result Fannie Mae continued accumulating mortgages throughout boom years of this and previous decades and in doing so helped magnify the mortgage bubble. Ironically at just the point when Fannie Mae should be stepping back into the mortgage market it is instead requiring its own bailout. An institution which helped fix the first Great Depression inadvertently helped generate what may yet become the second Great Depression.

The second lesson concerns the dangers of state managed exchange rates. After World War II the Bretton Woods system of pegged currency exchange rates was used to fix the problem of competitive currency devaluations. More recently a similar arrangement, now referred to as Bretton Woods II, has been used by China and other developing countries to fix the problem of emerging market currency crises.

Initially both the original Bretton Woods system and today's emerging market currency pegs were mutually beneficial; Bretton Woods I accelerated the re-industrialisation of Europe and Japan after WWII and lately Bretton Woods II accelerated the industrialisation of China and other emerging economies. But in both cases as the industrialising economies caught up with the American economy the pegged exchange rates became increasingly inappropriate.

By the 1960s the economic output of Europe and Japan had significantly caught up with that of America but their currency valuations had not kept pace with this progress. As a result America began sending a flood of dollars abroad to buy their cheap goods. Ordinarily this outflow of American dollars would have depressed the value of the US dollar and corrected the trade imbalance. Instead, due to the fixed exchange rate agreement, foreign countries automatically recycled their trade surpluses back into America to prevent the dollar from falling in value. Today the same arrangement is replicated particularly with the pegging of the Chinese currency. Unfortunately while the currency pegs remain in place any amount of American borrowing from abroad is automatically matched, dollar for dollar, with foreign lending. In both the sixties and in this decade this arrangement allowed and encouraged America to accumulate what ultimately became an unserviceable debt burden.

The pegging of exchange rates was a cure for currency crises but the cure became cause of subsequent debt crises. This arrangement is particularly problematic when the pegged exchange rates are between countries with significantly different rates of economic growth.

The third lesson concerns the dangers of the state trying to over manage economic cycles. In the 1990's the Federal Reserve adopted a 'risk management paradigm' as described by Alan Greenspan in 2003: "At times, policy practitioners operating under a risk-management paradigm may be led to undertake actions intended to provide some insurance against the emergence of especially adverse outcomes. For example, following the Russian debt default in the fall of 1998, the Federal Open Market Committee (FOMC) eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, was likely to continue to do so." In other words, the Fed began using monetary policy not reactively in response to economic crises but proactively to prevent crises.

The risk management paradigm was tremendously successful at heading off, or significantly moderating, recessions, so much so that economists began talking of 'the great moderation,' as described by the then Fed governor Ben Bernanke in 2004: "One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. ...Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation 'the Great Moderation'."

Unfortunately those using the risk management paradigm to prevent crises failed to heed the message of great economist Hyman Minsky who famously warned: 'stability creates instability'. As the Fed became more adept at pre-empting crises households became accustomed to greater certainty of income and employment, and with this greater certainty came a greater willingness to borrow. Today's unserviceable household debt is in part attributable the excessive confidence imparted by the Fed's over management of previous economic cycles.

Individually each of these stories has a specific lesson our leaders: state subsidies of lending should last only as long as absolutely necessary; free trade of goods and capital is a marvellous idea but only when accompanied with equally free exchange rates; the occasional recession provides a painful but essential economic discipline.

Collectively these stories suggest two additional lessons. Firstly, when seeking to apportion blame for this crisis our governments and central banks should be willing to examine their own role as critically as they are now judging the private sector financial system. Secondly, history teaches that the fixes we implement today may well generate the problems of tomorrow - temporary solutions may be best.

George Cooper is the author of "The Origin of Financial Crises: Central banks, credit bubbles and the efficient market fallacy" (Vintage Books)

Comments

[peterg76]

Unless, of course, the "current financial crisis" is just a scam.

[biabouman41]

These are some valid points, that failure to re-adjust for the adjustment just made will result in derailment. But you failed to point out the biggest problem in the current banking crisis is the deregulation started by Reagan was accelerated through the years, by both political parties and a re-adjustment was needed at some point, but never came. The absence of this re-adjustment lead to the Banks "bundling" mortgages they did not understood. Regulators should have been there to say "no you can't". We needed to regulate again.
Simirlarly, when we do regulate, there always is a point at which that benefit that was first dirived now dissipates. We must bit by bit go back in the opposite direction and deregulate.
Your basic point that when you turn the car's steering wheel to the right, if you do not soon correct for that move, you will go off the road. AND WE ARE OFF THE ROAD.

[DuganS1]

The biggest moves toward deregulation were accomplished by President Jimmy Carter, not President Reagan.

[Lilly06]

Really? Tell me how?

[Sundialsvc4]

A very well-considered article, George, but I do believe that you under-stated the damage that could be caused by a situation that, I aver, has indeed occurred...

What if the line was intentionally blurred between the "civil officers" of the Government-in-question, and the "private businesses" that they were supposed to both regulate and protect?

What if there was something unimaginably vast ... "Ike" called it "The Military Industrial Congressional Complex" before striking that fourth word in the final text ... that it could exert a corrupting influence upon everything that it touches? What if the people who were charged with making "government" decisions (and they are, after all, "people too") were NOT acting in the best fiduciary interests of their constituents, and in fact were behaving otherwise?

I freely confess that I have not yet read your book... I will certainly make it my business to promptly do so... but do these "oh so human, and oh-so-humanly ULTERIOR" motivations, that I hereby suggest, figure into the world-view that you have expressed in that volume?

[tompoe]

In other words, the Bush administration, and the Republicans who fought so hard for free market, to the point of ignoring the housing bubble facts, is to blame. What's astounding to everyone who is hit by the bailout for corporate welfare entitlements of Bush and the Republicans, is the blatant, arrogant and continuing raping and pillaging by the government and central banks. Stop!!

[tomas0808]

I'm afraid the entire western world needs a good ten year depression and the resulting savagery to remind ourselves of what's important in life and re-establish some value to a workers physical labor.

[Sundialsvc4]

We are going to have to squeeze-out a lot of "leprechaun gold" that does not exist. According to an article in this month's "New Yorker" magazine, the supply of cash produced by derivatives is at least eight times larger than the total economic value of the world's production. That gold has just turned back into the straw that it always was.

Industrial production. We do not need the status-quo whereby the United States was singularly responsible for more than one-half of the world's industry, but we do need to maintain a situation where all of the nations who are trading with one another are also producing ... first for themselves, then for trade. I am of the opinion that we cannot meaningfully remove that element from the picture ... and I hasten to add that I don't think Dr. Cooper did so, nor intended that we should.

Our situation is not only that we have utterly lost-control of our ledger books (finding them now awash with smelly straw...), but that we have neglected to properly tend our own fields. If we put ourselves to setting-aright the briefly mothballed industrial capacity that we still have, what we see writ upon our ledger-books will begin to correct themselves ... albeit with much smaller numbers.

[Zeje]

A depression will only further devalue workers physical labor.

[Idytme]

As someone pointed out on CNBC, loans by Fannie Mae were by definition not subprime. Fannie has a default rate of something like 1.7% while the person quoted said that the other holders of mortgages had default rates reaching 20%. It is on the republican agenda to bash Fannie so they can try to blame it on the democrats. We have been in housing crisis' before and it has never brought down the world economy. What set this off was excessive leveraging of up to 40:1, and all the derivative products, CDO's and the likes. It has been said that the derivative market is bigger than the global economy, and by some people's estimates by lots. This is a hidden market and no one knows who owns what, but all of it was essentially gambling that was sold as financial products. The problem was no regulation from the beginning. Wall Street brought this onto us.

[ChimesOfFreedom]

That's correct - we've had housing downturns before, but we've not had companies like AIG (Party Central) selling CDS without sufficient capital to back them to organizations that have no actual stake in the mortgages being insured. Once the defaults started happening in a big way, AIG had no way to cover those liabilities, and that was going to take down their legitimate insurance business, which is in fact quite profitable.

Now they got away with selling unfunded CDS (it's great collecting those fees for nothing, until the bubble bursts) because the Congress, led by Phil Gramm et al, deregulated them, and Alan Greenspan went along with it, because he just couldn't imagine that those companies would ever be so irresponsible as to not regulate themselves.

There are by some accounts many trillions of dollars worth of credit default swaps - some of which were sold as insurance on other swaps - out there, so AIG may only be the tip of a very large iceberg. Subprime loans and defaults on such loans are not the real problem. Deregulation that allowed outrageous levels of gambling in the financial markets is the problem.

[Rast262]

Nobody knows for sure, but the latest valuation of CDS put them at about 62 Trillion dollars. (According to ISDA.org)

To put that in perspective, according to the IMF the 2007 Global GDP was 64.9 Trillion dollars.

[ChimesOfFreedom]

I should add that it is also a problem that we have an economy so difficult for the average family to survive in that so many people took on mortgages that they ultimately would not be able to afford once the rates reset - that so many people were desperate for some short -term financial relief that they were willing to make ridiculous bets on their own long-term ability to pay.

[ChimesOfFreedom]

I thought this was supposed to be "An Explanation of the Current Financial Crisis," but there isn't a single mention of credit default swaps or their deregulation, or Greenspan's blind faith in the ability of the financial institutions that used them to regulate themselves. It is the unregulated (and non-asset-backed) CDS, after all, that is at the heart of the burden on AIG, for example, which burden is now being shouldered by the American taxpayer.

[joebhed]

Don't you realize?
It's always the government.
Either what they do, or what they don't do.
Or when they fail to re-adjust their adjustment in the re-adjustment peiod.
Or, when the government over-adjusts when it should be under-adjusting the adjustment.
It MUST be the government.
And, by GOVERNMENT, we mean the federal reseve central banking system.
Which, as it turns out, is NOT the government, but the private bankers.
Means nothing.
They are the central bank.
SO, they are the government.
It is the government's fault in letting them do the adjustments.
it is the government's fault for NOT lettign them re-adjust the deflationary aggregate indicator.
Ah, to be an economist.
How about this?
The cause of the currently emerging financial crisis is the debt-money system.
Plain and simple.
That is the CAUSE of the bubbles.
And THAT is the cause of the pro-cyclical pace of the contraction.
So, hang on.
When you're at the bottom, start re-adjusting.
The debt-money system.