Monday, 22 September 2008

What a great time to be an economist…rather than banker...

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.


Matthew Wilkinson said...

People are greedy, we all know that. In a risky world, where the motivation is to take further risk for higher returns, this has a habit of catching up with you.

The financial market, being the fabric of the capitalist machine, there will be no end of similar credit crunches in the future given our current system. When the government's of America and England are forced to step in and bail out the banks and financial markets to save the economy - surely financial markets are incentivized to misprice risk.

NightBlue said...

Thank you for providing such opportunity to us. I have been searching for such an opportunity for long time.
Economies require impulsions to move. The impulsions for an economy can be a process like `globalisation` or a state of political hostility and military tension such as ` the cold war`. The primary matter for the policymakers is to design new impulsions when the old one is losing its effect.
From this point of view, high petrol prices and the massive US current account deficit were the impulsions of the world economy between 2002 and 2006. In this period, the world dollar stock significantly increased and the dollars were pumped into domestic markets through financial centers of the world. Dollars were converted into domestic currencies and thus, the stock of domestic currency rose. From one hand, it created a downward pressure on interest rates, from the other hand, the domestic currency appreciated due to the contionous dollar inflow into domestic markets. The appreciated currency and low interest rates helped to control inflation rates.
The increase in both domestic and foreign money stock stimulated the banking sector to increase consumer credits. Thus, the grown spriral was created.
As a result, the world witnessed a strong economic growth period from east to west, from south to north -dollar pumping into domestic markets have carried the world economy between 2002 and 2006.
The expansion period coincided with dramatic advances in computer and telecommunication technologies. These advances helped to invest in foreign markets. Many funds invested in mortgage backed securities issued in the US market.
The financial system consumed much of its liquidity, in an expectation of interrupped economic growth. Thus, the highly leveraged balance sheets of the system posed a potential upward risk on interest rates. Moreover, the systems` emergency buffer for a monetary stock shrunk.
The footsteps of the crisis were coming at the end of 2005. High leverage levels, low cash/ total liabilities ratio, the interruption in the upward momentum of petrol prices, the increase in charge off levels of residental real estates, and the massive expansion of -mostly- unregulated derivatives market were some early signals of it.
In my opinion, the real situation in the crisis is not such bad. However, many investors prefer to close their investment positions. The previous period is over. Now, it is the time for a new market turn. Which forces will play an effective role in the new market? Nobody knows the answer. Therefore, players are waiting for the result of the presidental election held in the US. New president will bring new policies and then investors may forecast the new forces and then they can open position again. People do not want to invest in any commodity or security nowadays, because they can not see future. The world economy needs new impulsions which will shoulder the world economy for a new period. These impulsions will be created in Washington as it is dominating the world economy for some decades.