Explaining the crisis (1)

The global financial system looks complicated, but is simple, even though it does not present itself as simple. True, it's not easy to grasp its simplicity. Once I made an effort, in a long article, "The Monetary Crunch: Crisis or Scandal?" (to be put soon on the Fondad website), and I was not fully satisfied.

I have received several papers in response to my request for articles about the international credit crisis (which started last year as a subprime mortgage crisis in the US). In the first two posts on explaining the crisis, I'd like to discuss unpublished papers by John Williamson and Andrew Sheng.

The first time I came across John's name was in the early 1980s, when I spoke to Robert Triffin who referred to him. Ten years later, I had the pleasure of inviting him to a Fondad conference about "The Functioning of the International Monetary System" (see Fragile Finance). Since then John has been a great contributor to Fondad conferences and books.

I saw Andrew's name for the first time in the early 1990s. Last year I invited him to a Fondad conference in Kuala Lumpur about "Globalisation, Asian Economic Integration, and National Development Strategies: Challenges to Asia in a Fast-Changing World". I enjoyed Andrew's contributions in the conference and our private conversations.

My assertion that the global financial system is, or ought to be, a simple matter departs from the idea that the crucial variable in the system is prices: prices of assets (houses, for example) and prices of loans (payment of interest and repayment of principal), or whatever else that carries prices. What is there more simple than prices?

It is the essence of prices that they can rise and fall, and so do the prices of assets and loans. Nothing complicated.

The complication begins when people expect prices to be stable. Then you are in for trouble. As John says, "trouble started when house prices [in the US] stopped rising and started falling".

However, bankers and central bankers should have expected the falling of house prices since booms do not go on for ever. "The existence of a boom must have been clear even to central bankers (some of whom assert that they cannot be expected to identify bubbles)," says John.

Again, this has nothing to do with "complicated" economics, it's just the simple behaviour of commercial bankers (lenders), house owners (borrowers), and central bankers (regulators and supervisors).

Where then is the complication in the subprime mortgage loan crisis? In the slicing, dicing and packaging of the subprime mortgages into new financial instruments such as "special investment vehicles", says John.

As a result, "financial intermediaries did not know where many of the losses would end up, and to avoid unpleasant surprises they aimed to stop lending even to counterparties that would normally have been regarded as rock-solid."

So it is the panic and uncertainty that led to the subprime mortgage crisis in August 2007.

Then, as with previous financial crises, the crisis quickly spread and deepened. "While the first impact was on the mortgage and interbank markets, many additional assets have now been affected," observes John.

This is also nothing new. From previous crises we know that chain reactions happen.

As John says, "A fall in the value of certain assets triggers calls for increased collateral ... by those who have used those assets as collateral ... the affected institutions are forced to sell other assets, whose prices therefore fall; and that in turn sets the stage for the further propagation of the crisis."

Instead of chain reaction you can also call it "contagion" -- not a very complicated economic notion either.

So it seems that financial crises have more to do with (mass) psychology than anything else: expectations, uncertainty, fear, herd behaviour, contagion, etcetera.

In the next posts, I will continue discussing John's ideas and I will include thoughts of Andrew as well as those of others. I just glanced at the opening lines of a front page article in Le Monde Diplomatique, "Crises financières, n'en tirer aucune leçon..." Will it contain interesting thoughts?