What we are seeing is the bursting of yet another bubble, a bubble whose seeds were sown ironically, by the response of central banks to the bursting of the last bubble: the tech bubble.
In the aftermath, central banks took interest rates to multi-generational lows, and subsequently countries running current account surpluses û in Asia, Russia and the Middle East û flooded the world with liquidity, out of a desire to stop their currencies from appreciating. As a result of actions by central banks both in the developed world and the developing world, you saw a massive flood of relatively cheap money. Wherever that happens, you get a bubble somewhere. In the past it has been in equity market and in this case it was in the debt markets. This bubble had the usual characteristics of bubbles: there was significant innovation (in this case, in financing techniques); a belief that this time it was different; and irrational exuberance, which participants refused to acknowledge.
Hence even after interest rates began to rise, and property prices to flatten, those writing subprime mortgages did not pull back. ItÆs a generic problem in financial markets that people running businesses are almost pathologically unable to admit that the circumstances in which they are running them have changed û so that they cannot maintain their previous momentum of revenue growth. So rather than wind back some of this subprime lending û some of which has enabled people to become home owners who otherwise would not have been able to do so, which is generally-speaking a desirable thing û they were either unwilling or unable to wind back, and instead we saw a general deterioration in lending standards. It was in this period û rather than in 2002-2004 û that the seeds for the present crisis were sown.
On top of that you had all of the financial innovation that led to the dispersion of exotic products based on subprime mortgages to investors all over the world. What you have now is a situation which in every respect but one is like previous bank runs. That is to say, banks are in the business of borrowing short, lending long; borrowing in liquid markets, and lending in illiquid ones; and whenever the values of loans have deteriorated, they have been concentrated on the books of the banks that wrote them, and some of those banks have failed. When that happens the solution is well known and obvious: you force full disclosure of who has done what, you make decisions about which institutions will fail and survive, and where necessary put public money into the latter. You justify this to the public by the need to protect the smooth running of the financial system and protect peoplesÆ savings.
This is like that, except that the risk doesnÆt sit on the books of banks, has been widely distributed around the world. Therein lies the difficulty of resolving it. First off, there is no obvious way to force a public disclosure or confession as to who has lost how much; nor is there any obvious way to bring public funds in to clean it up. And while governmentÆs have fiduciary responsibilities to depositors they donÆt and shouldnÆt have them to investors. Yet in the absence of those two steps, there is no easy way to restore the faith and trust which is at the heart of the business of lending. Hence, the resulting situation.
Will interest rate cuts do the trick?
Yes, they will be part of it. Not only for that reason, but because central banks need to offset the tightening of monetary policy that markets themselves have imposed. If you look at the rate borrowers are actually paying û if they are able to borrow û and in some cases good credits, such as solvent banks û are now paying 30-50bp more in most countries for 30-90 day money than they were six weeks ago.
The balance of risks, the Fed has admitted, has moved from inflation to lower growth, and so they not only have to offset that de facto tightening of monetary policy, but they may have to do more. And in Japan and Europe, where the central banks were thinking of tightening monetary policy, the markets have done it for them.
The Fed certainly needs to cut rates by a quarter, and they may need to cut by more than that depending on what the data and their judgement tells them about what is happening to the real economy
Will a rate cut be enough to bring back confidence?
Eventually, yes. But no one at this stage û least of all me û knows how much they will need to do. You cannot predict sentiment. But in Asia there is a lot of economic momentum and it may well be that if the credit mechanism is restarted quickly enough, then no significant damage will be done to the real economy.
But central banks walk a fine line. They must be careful not to bail people out who have made imprudent decisions. But they also donÆt want to go too far to make an intellectual point about moral hazard. They donÆt want to be like the Americans in Vietnam who destroyed villages in order to save them.
Rather like the LTCM bankruptcy, will a major financial institution be a victim of this crisis?
It is unlikely, because the banks are not the ones holding the risk now. The originate to distribute model of banking has succeeded in spreading the risk around; although banks are now learning that it hasnÆt dispersed the risk as widely or as permanently as they thought. Banks have had to take loans back onto their books û that they thought they had got off û through conduits and SIVs. And in many cases, where banks have provided standby credit facilities along with underwriting of securities, they have had to honour them. So not all the risks have been as dispersed as was previously thought.
I suspect that in the future, regulators will have to give a lot more thought to what off-balance sheet really means, how off-balance sheet they really are, and whether capital still needs to be allocated against them.
As an economist you obviously rely on data. Is this crisis different from those before because û over the last 6-8 weeks û there has been such an absence of high quality data with which to analyse what is really going on?
ThatÆs a really serious problem, and it goes to my earlier point. We need to find a way to force much greater disclosure of who holds what? ThatÆs an integral way of resolving any banking crisis. You cannot get a solution until you know who has lost what and what the consequences are for the stability of those particular institutions.
At the end of the day, if it is hedge funds falling over, I donÆt think that has any more systemic consequences than the loss of equity in the tech bubble. Now the tech bubble wasnÆt a credit event û it didnÆt go to the heart of financial institutions who take deposits. This one may do, to some extent. But we need to discover the extent to which those who want continued access to borrowing are affected and those who have simply destroyed equity capital of their own. ThatÆs a key difference. But because it has been so widely dispersed between different regulatory systems, it is not obvious yet what the mechanism is for achieving that outcome. Yet, until it is achieved, markets are going to operate on the basis of guilty until proven completely innocent when making lending decisions. Until you can get over that it is hard to see how the credit mechanism can be restarted.
Six months from now will we still be talking about an Asian bull market, or will things fundamentally have changed?
We could be. Asia is structurally less likely to be affected by this than other parts of the world. This is the mirror image of the crisis a decade ago. Then, it was borrowing from Western and Japanese markets to finance its growth. It was dependent on a flow of capital from abroad. Today, Asia is running current account surpluses and has been providing liquidity to the world. So the turning off of that liquidity will not affect its growth.
To be sure, Asian investors and financial institutions will have some of this toxic debt on their books. And will have to confess to how much they have lost. But I doubt there are many institutions in Asia û that matter û whose fundamental stability will be put at risk by those losses. In a sense, Asia has spent the last 10 years taking out insurance against the events that laid Asia low 10 years ago û and that will insulate Asia from some of those things. But people who write insurance, take a hit when claims are made, and that is effectively what is happening at the moment.
But as far as the Asian economies are concerned they should be resilient. If there is a recession in the US û it is not more forecast, but it is a risk û then there will be adverse consequences for economic growth. But what we are talking about is maybe a percentage point off AsiaÆs growth rate, not a recession.
As far as Asian equity markets are concerned: if the central banks succeed in restarting the credit mechanimsm, part of the means by which they will do that is by cutting interest rates. Lower interest rates, combined with what is fairly good growth, should be good for Asian equity markets, particularly since û China aside û they are not really overvalued.
I am reasonably optimistic about Asia and AustraliaÆs ability to weather this event if central banks succeed in restarting the credit mechanism pretty soon. I think, however, there is more bad news out there. What I am hopeful of is that the authorities will get the bad news out, and deal with it in time-honoured ways, and let us move on. If they can do that, then this part of the world will be okay.
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