I am writing this three two days after the parent company of Lehman Brothers has filed for Chapter 11 protection, one day after the US Government has agreed to inject capital into AIG and hours after CDS rates on a strong firm such as Morgan Stanley have widened significantly. To many, it seems like the end of the financial system as we know it is near. The question is: How deep will this crisis go ? What shoe will drop next ? How much of our financial infrastructure lies open to destruction ?
The end-game, I believe, lies not with the financial economy in the narrow sense, but with the economy as a whole. How much more money can nations source to prop up what remains of our financial system ? In this, we have to remember that all of the (generally central bank-originated) measures that we have come to know have never existed to change the overall pattern of growth, but simply to smooth out the inevitable ups and downs that take us away from the long-term growth rate of the economy, what some call the 'business cycle'. Interest rates have never been a weapon to radically change the direction of our economy, they have simply served to prop us up when we are, temporarily, down, and to hold us back when we are getting ahead of ourselves. The long-term path of our economy depends on much larger variables, which no central bank or central government has ever been able to control.
When we think of the end-game in this whole sorry saga, we should therefore think of the big picture. The end-game consists of the collective power that any nation has to create, or destroy, economic growth that finances, or lacks the ability to finance, the overall growth that we enjoy, or lack. And in that sense, I believe the balance is largely positive. More financial institutions may go bust, or not go bust for the mere intervention of incredibly powerful government intervention. But that government intervention can only be financed by our collective ability to create long-term growth, our collective ability, as an economy, to profitably solve problems that we would all like to see solved - and that ability is unaffected.
Large government deficits will be created in getting through the current crisis. But I believe that those deficits will, in the long run, be financed by our joint ability to create value. Much remains to be done in this world that is far from trivial. Billions of us are looking for food, clean water and a life expectancy that has escaped them for too long. Legions of hard-working people in our developed, and less-developed, economies can create value by providing those solutions and can therefore finance the necessary sacrifices that we need to make right now. The present seems bleak, and we will no doubt go through a difficult couple of days. But the long-term picture is one in which much opportunity exists - and we have all the resources at our disposal to grab that opportunity and to put our economies, including our financial sectors, on a sound footing. It certainly is crunch time. But we can get through the crunch by realising the immense opportunity we have to create wealth and to pay off the deficits that, necessarily, we are incurring to get through these hard times.
Wednesday 17 September 2008
Does this crisis mean we need more, not less, market ? Am I going to get flamed for even suggesting this ?
More and more commentators are starting to point to the weaknesses of the market system and how they contributed to, even caused, the current credit crunch and accompanying crises [quotes needed]. However, two key factors contributing to this crisis (the two key factors, some would say) are not so much market-based but to do with government and planning.
Firstly, central banks' interest rates. Some point to interest rates being too low for too long as a key factor in the inflation of asset prices (which is a problem when economic subjects start loading up on leverage under the assumption that no deflation will ever take place). Central banks, however, are government institutions (they may be independent or a-political but are still integral parts of the political organisation of most nations). Very capable central bankers may have kept interest rates low with the best of intentions, but would it be an idea to replace this system, usually consisting of a number of wise men periodically getting together in a room and setting one or more interest rates central to our economy, by a market-based system ? Why not let institutions that demand money bid for it, thereby setting a much more natural rate of interest ? When demand is high, interest rates would go up, when demand is low, interest rates would go down. Much more details need to be worked out (e.g. how much money would be on offer at each session) but I think a market-based system should at least be considered as a much more efficient way of setting interest rates central to the economy.
Secondly, rating agencies. I am quite surprised that, in the current crisis, rating agencies seem to be getting of scot-free, while they are the ones that 'laundered' many of the financial products that now turn out to be toxic to its buyers. Is it not the fault of credit analysts at rating agencies that subprime mortgages were, incorrectly as it now turns out, converted into some tranches of AAA paper ? Rather than just the programmatic analysis of the kind usually performed by the small number of analysts that compose these companies, would it make sense to also create a market-based system that continuously evaluates these securities ? A sort of 'twitter for CDOs' that shows how positively or negatively a large number of market participants feel about a certain financial instrument. In the current crisis, some people blindly believee in the"AAA" rubberstamping of some instruments by some analysts, and used these ratings as an excuse for not having to understand the instruments themselves. A market-based system could at least provide a second opinion or create more of a discussion where now there is neither.
Of course, no market-based system is perfect. We know markets are subject to over- and under-shooting and we are gradually finding out that even some of the most sophisticated markets are liable to manipulation from time to time (there seems to be a worrying trend for short-sellers to do well off the back of spreading specious rumours these days), but I believe that markets can help in the current crisis where institutions and some regulation failed. And if those markets can be made ever more transparent, for example by clearly attributing opinions and information to the parties that distribute them, this could be a valuable contribution to avoiding similar crises in future.
Firstly, central banks' interest rates. Some point to interest rates being too low for too long as a key factor in the inflation of asset prices (which is a problem when economic subjects start loading up on leverage under the assumption that no deflation will ever take place). Central banks, however, are government institutions (they may be independent or a-political but are still integral parts of the political organisation of most nations). Very capable central bankers may have kept interest rates low with the best of intentions, but would it be an idea to replace this system, usually consisting of a number of wise men periodically getting together in a room and setting one or more interest rates central to our economy, by a market-based system ? Why not let institutions that demand money bid for it, thereby setting a much more natural rate of interest ? When demand is high, interest rates would go up, when demand is low, interest rates would go down. Much more details need to be worked out (e.g. how much money would be on offer at each session) but I think a market-based system should at least be considered as a much more efficient way of setting interest rates central to the economy.
Secondly, rating agencies. I am quite surprised that, in the current crisis, rating agencies seem to be getting of scot-free, while they are the ones that 'laundered' many of the financial products that now turn out to be toxic to its buyers. Is it not the fault of credit analysts at rating agencies that subprime mortgages were, incorrectly as it now turns out, converted into some tranches of AAA paper ? Rather than just the programmatic analysis of the kind usually performed by the small number of analysts that compose these companies, would it make sense to also create a market-based system that continuously evaluates these securities ? A sort of 'twitter for CDOs' that shows how positively or negatively a large number of market participants feel about a certain financial instrument. In the current crisis, some people blindly believee in the"AAA" rubberstamping of some instruments by some analysts, and used these ratings as an excuse for not having to understand the instruments themselves. A market-based system could at least provide a second opinion or create more of a discussion where now there is neither.
Of course, no market-based system is perfect. We know markets are subject to over- and under-shooting and we are gradually finding out that even some of the most sophisticated markets are liable to manipulation from time to time (there seems to be a worrying trend for short-sellers to do well off the back of spreading specious rumours these days), but I believe that markets can help in the current crisis where institutions and some regulation failed. And if those markets can be made ever more transparent, for example by clearly attributing opinions and information to the parties that distribute them, this could be a valuable contribution to avoiding similar crises in future.
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