The financial crisis has dominated the headlines for over a year now and provided a chronic migraine to bankers, policymakers and academic economists as we try to locate the causes, cures and consequences of this crisis. Whilst I am not going to provide a definitive answer in this column (yet), what I think I can do is set the scene in the first instance about some causes of this crisis. I will deal with some other aspects in future weeks.
Early commentary on the current financial crisis treated it as a necessary re-pricing of market risk and it is still difficult to disagree with that basic point. Promulgated by the emergent-saver nations, such China, world interest rates fell in the past decade or so. And taking a lead from Japan and then the US, the early years of the 21st century had been characterised by low policy rates, which were accompanied by a widely-offered argument about the possible end of the business cycle and a series of innovative ways for the financial sector to expand the liquidity of financial intermediaries. All of which perhaps contributed to a sense of hubris or infallibility within the financial sector and in the wider economy and certainly a sense that risk had somehow dissipated. Accordingly, the price of risk fell as likelihood of bad outcomes was collectively judged to have fallen markedly.
Under these circumstances, asset prices could not help but be bid up and the risk premia required by investors to hold various classes of risk evaporated. High asset prices provided the means for further liquidity creation for the private sector, as owners of capital and homes found themselves with bankable quantities of equity. They also provided an impetus to financial engineering, with liquidity combining with a search for yield to produce new methods of handling the consequences of financial intermediation. Banks found that they could borrow their liabilities increasingly from other banks rather than from arguably more reliable retail customers and create loans (assets) that would amount to many times their underlying level of capital.
The relaxation of credit constraints provided a boost to economic activity, which might typically have been managed with a temporary increase in policy rates to ensure that demand did not run away from the gradual increase in supply. But at the same time there was a deflationary impetus from newly industrialising economies that placed downward pressure on traded goods inflation. So that inflation targeting, in some cases quasi-inflation targeting, central banks did not feel that it was necessary to raise policy rates to a sufficient degree. And so the long expansion, or what we might eventually look back upon as a boom, continued unabated.
It was argued that the overall risk from extending loans could be mitigated by more sophisticated forms of risk management (which we will explore in future weeks). But as loans are extended to more and more agents, the quality of the marginal agent – in terms of ability to repay - will at some point deteriorate. Escalating debt levels and greater coverage of loans amongst a given population leads to two possible sources of instability, that the private sector expectations about the path of interest rates and the growth of future income have been too optimistic and that the asset price-based collateral used to back a given loan may deteriorate. The former will make debt service more difficult and any downward shock to asset prices will increase the implied level of gearing for any loan and so threaten net worth. And so it would seem that higher levels of more widespread debt may actually tend to increase overall market risk.
To some extent this is indeed what happened. Even though risk was spread amongst many financial institutions many of the original loans became riskier. So we ended up with a position of low market rates, high asset prices and escalating rather than declining economic risk. The trinity is impossible and something would have to change and in this case it was the first two relative prices. Banks and private individuals both had to re-assess the viability of their balance sheets and seem to have come to a similar conclusion that capital and savings have to increase. Households may be able save, if their income flows are maintained but that is a big if, but banks cannot re-capitalise when liquidity is low and so governments came to the rescue with a fiscal bail-out.
To some extent the crisis has finally come to a head in the past week. The recent bail out of two large Government sponsored enterprises, Fannie Mae and Freddie Mac, the bankruptcy of the once-venerable institution Lehman Brothers and the take-over of HBOS by Lloyds TSB. It seems likely now that the as well as continuing to offer short term liquidity to help banks finance their ongoing operations, there will be some attempt by the US authorities to buy up the bad assets from banks who own them at a deep discount and hope fully try to develop some form of secondary market for these assets.
If we are now to move from a regime of easy money (low interest rates, low inflation, high asset prices and high gearing) to one of tighter money (higher interest rates, higher inflation, lower asset prices and lower gearing) what are the implications? By which I mean what will the landscape of the financial and banking system look like, how will it be regulated and how will the transition from one regime to the other be managed.
In a market economy, with collateral required for lending, raising the required rate of return on marginal projects will reduce the level of capital employed in the long run and hence the rate of economic growth. So we will have to transition to a lower than expected level of growth. The transition will probably lead to a public and private debt overhang, along with further possible bail-outs for the financial sector. And the danger is that this will change the terms of trade for monetary policy, particularly as deflation will have to be avoided, with a strong inflationary incentive re-emerging. Tighter regulation of the banking and financial sector will be difficult to avoid and so we may end up with an economy that ultimately is less reliant on the financial sector for its growth, I am not quite sure that lower growth, higher inflation, higher taxes and a less dynamic financial sector will be preferred by all. But if the alternative is occasional busts on this scale, there may in fact be little alternative, even if we did mostly enjoy the ride.