Monday, 16 March 2009

Feedback from the Credit Crunch Seminar 1

Here are a few notes from the talk Simon Clark gave at the Credit Crunch Seminar on 12 March (see posting below). They are addressed mostly at the question of why it has happened. Bear in mind that the audience consisted not of academic economists, or even economics students, but of ordinary citizens, worried, angry, and vocal.

I don’t think we really fully understand why we are in the mess we are.

For one thing, we didn't see it coming: and that has been one of the important characteristics of the crisis: two or three years ago, many people, perhaps most – including politicians, bankers, economists – would have said that the UK economy was pretty healthy: we had had a decade or so of strong economic growth, and inflation and unemployment were low.

Even when the financial rumblings started in 2007, as the bad sub-prime loans started to surface in the US, even when Northern Rock had to be rescued – the first bank run in the UK for over a century – I don’t think many people foresaw how quickly the financial crisis would develop and deepen, and how quickly it would spread to the real economy.

Nevertheless I think we can offer a narrative, a drama in 1, 2, 3, who knows how many acts? The best place to start seems to be the US sub-prime market. The realisation that many of these loans were ‘bad debts’, unlikely to be repaid, had implications far beyond the US mortgage market. It was the immediate cause of the what one might call the central event in Act 1, namely the collapse of liquidity and the collapse of the interbank market. The main reason for this was the that the sub-prime loans were bundled up, repackaged with other assets, and sold on in the form of ‘collateralized debt obligations’. But these financial assets were so complex that very few people understood them, even the senior managers of supposedly reputable investment banks.

As banks became wary of other banks ability to repay, so they were less willing to lend to them – the interbank market dried up, and those institutions that were reliant on this kind of borrowing to finance their own lending - for example Northern Rock – were caught up. Northern Rock’s mortgages were nowhere near as bad as the sub-primes, but it did not have a solid retail base of many small depositors.

So, we had a kind of contagion that affected all financial institutions. The response of governments was uneven and unsure; they were faced with the choice of bailing banks out – offering guarantees, providing capital, lending taxpayers’ money – or holding back and letting ‘market forces’ sort things out. This second option had the supposed advantage that it did not encourage ‘moral hazard’: the phenomenon that if you forgive bad behaviour, you make it more worthwhile. This was initially the preoccupation of Mervyn King, the governor of the Bank of England, and also of the US authorities. In the US, Hank Paulson, the US Treasury Secretary, decided to give the capitalists a lesson in capitalism, and let Lehman Brothers, one of the biggest financial institutions in the world, go bust. By the end of Act 1, there was some serious blood on the stage.

It was now apparent that no institution, however big, was immune; no bank was too big to fail. If you had to pinpoint one event when the crisis spread beyond the financial sector, when it went from a local, possibly containable, problem of liquidity, to a full blown global economic problem, it was the collapse of Lehman Brothers. All banks were suspect, no one wanted to lend to banks, including other banks, and so banks themselves had less money to lend.

Act 2, then... [more]

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