Most people have reacted to the collapse of Lehman brothers, demise of Merrill Lynch, nationalisation of AIG and so on in predictable ways. George Bush and John Paulson say the US financial system is sound and flexible; in an editorial today, the Times says it all proves that markets are working; the head of the TUC is calling for the Government to do something to help the "ordinary" victims. And Sir Simon Jenkins has produced the most thoughtful piece I've come across so far, in the Guardian.
Just about everyone is blaming the crisis on the decline in the US housing market. That's true as far as it goes, but it doesn't go nearly far enough. The US housing market has fallen apart because it was wildly overinflated in the first place, and that's largely down to an abject failure of US monetary policy during the Greenspan years. I've written enough (or more than that) about this in the past, but in essence Greenspan presided over a period of exceptionally low interest rates and rapid money supply growth. Thanks to the entirely coincidental expansion in the supply of cheap goods from China and elsewhere, this did not trigger the rise in consumer prices that would normally have been expected. Greenspan appears genuinely to have believed that the credit for the low inflation era belonged to him, so instead of being cautious, he just kept pumpimg up the volume.
All this cheap and abundant money had to go somewhere, and it went into assets. So stock prices and house prices began to rise, not just in the US but all around the world. Greenspan never seemed to see this as a problem. Although he once spooked the markets by talking about "irrational exuberance", he never actually did anything about it. In fact, he repeatedly denied that central banks could predict or forestall market excesses. Worse, each time the market seemed about to correct itself (the Russian debt crisis, the tech stock collapse, 9/11) he simply opened the money spigot even further, creating the "Greenspan put".
So far, so irresponsible. However, at the same time as the flood of cheap money began to distort the markets, there were major changes underway in the financial system itself. Regulation became generally lighter, in the US and around the world, and large parts of the financial system quietly went off the radar screen. The rise of LBOs and private capital reduced the role of the stock markets, while the largely unregulated hedge funds eroded the influence of more traditional investors. Many of these newer players were much less adequately capitalised than the more tightly regulated banks.
And everyone had access to much more powerful trading tools than ever before, thanks to the explosive rise in computing power. Options may have been around for a long time, but computing allowed them to mutate into new forms at a staggering pace. The first swap transactions took place only in the early 1980s, but that market quickly mushroomed into ever more complex forms. And the computer allowed trades to take place faster than ever before, sometimes without any human intervention. (It's worth recalling that Nick Leeson put Barings under by arbing microsecnd differences between the updating of Japanese stock prices on two separate exchanges).
There's nothing wrong with these developments in themselves, but in a world where the monetary authorities and the regulators seemed to agree that inflation and crises were a thing of the past, they were a recipe for trouble. It became all too easy for the math PhDs on the derivatives desks to persuade senior management to get into these new markets. The profits were good (or at least, they looked good when the deals were booked) and since nothing had gone wrong yet, it was easy to believe that nothing ever would go wrong, especially with the Greenspan put lurking helpfully in the background.
The very nature of the banks themselves allowed this almost piratical culture to take hold. It used to be a standing joke in the industry that the Japanese banks moved like a herd, but the truth is, almost all banks are guilty of this. If the chairman of bank A plays golf with the chairman of bank B and brags about how much money his firm is making out of credit default swaps, it's dollars to donuts that bank B will try to hire a CDS boffin within the week. Very few banks are immune to this. In addition, the traders are almost always rewarded on the basis of the expected profits at the time the deal is booked. In fact, if they don't get rewarded that way, they go somewhere else. But when deals have very long "tails" and there is no real precedent for how they are going to perform, this is absolutely the wrong way to compensate people.
So: the housing crisis is the result of insane monetary policy; light regulation; changes in the structure of the financial sector; massively increased computing power; the culture of banks themselves; and a flawed compensation system. These are not problems that can be solved simply by easing monetary policy, as the events of the past year, and especially the past week, have made abundantly clear.
Where do we go from here? There is talk on both sides of the Atlantic about a need for a thorough overhaul of the regulatory system, but that's going to take years. Banks themselves are changing their behaviour -- just try getting a mortgage in the UK -- but is anyone going to dare to take on the hedge funds? This is a genuine "crisis of capitalism", certainly the most serious since the great depression. In some ways it may be worse than that, because the underlying values of bank assets are almost impossible to calculate.
There are two things I like to keep in mind about the Great Depression. Whenever a financial advisor tells me that stocks always outperform in the long run, I ask him/her when US stock prices recovered to the level they had been before the 1929 crash. They never know the answer, which is 1954. That's a bit too long for someone of my age to wait! The second is that US policymakers never did find a way to end the Depression. As the Norwegian economist Axel Leijonhufvud wrote many years ago "sad to say, Schicklgruber did it". Let's hope we're luckier this time.
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