The timing of your bookÆs publication looks extremely prescient, given you must have started working on quite some time ago. Was that just luck?
Did we [the book was co-authored by Sean Carr] have a premonition of the current subprime crisis? The answer is no. But we had great confidence that sooner or later there would be another bout of volatility. The reason, as we argue in the book, is that the elements that drive crises are never eliminated by heightened regulation, and greater information management systems. Markets will always out-innovate the existing structures, and that is what has happened today.
The focus on 1907 is interesting in its own right. That year was a very dramatic one and we tell the story of a brief, sharp panic in the New York financial markets that radiated out to other markets û and was only quelled by JP Morgan shortly before he retired. It was significant because it also led to the creation of the Federal Reserve û meaning it is the last great financial crisis in the US before the FedÆs creation.
WhatÆs interesting is the elements of that panic actually appear in the crises weÆve seen since: the Asian flu crisis, the Russian bond default crisis, the Tequilia crisis. There are recurring elements. I liken financial crises to hurricanes. Each is unique but there are enough points of commonality that you can say æinvestors should pay attention to a few thingsÆ.
You are evidently an expert on the history of financial crises. The individual crisis normally happens in waves. How do you see the current crisis? Have we just had the first wave; and is it part of a broader, bigger wave of corrections?
I would say we are early in the process of corrections. Crises often take many weeks and often many months to play out. There are many reasons for this. One is that a crisis creates stresses on a system that radiates through a system. This process takes time û much like a patient fighting a fever that dies down and then spikes again.
The concept of a financial system is that the parts of that system are all linked to one another. When crisis breaks out in one part of the system, it will radiate to other parts. We show in our book that the ability of crisis to spread is assisted by the relative absence of safety buffers û and the absence of safety buffers is a feature of the late stage of financial expansions. Keynes said we should be less surprised by the recessions and crises in economic cycles, than by the expansions that precede them.
Thus it is that the crisis is a process of figuring out where the errors û of the previous expansion û have come to rest in the system. The crisis will gradually wash away the errors û often painfully, and causing great difficulty. Today we see that the error of the previous expansion derived from the financing of home mortgages in the US û to subprime borrowers who were not creditworthy. This error has found its way into pockets of the global financial system that remain to be fully discovered and revealed. We have already seen evidence of institutions in Germany, France and Australia entering difficulties because of holding material amounts of this paper. The crisis will ultimately reveal where else this paper is held.
We are at a very interesting moment right now. The regulatory system has good clarity about the soundness of many of the players in the financial system, such as banks. What we donÆt have clarity about is the standing of hedge funds and the investment vehicles that have been used to warehouse the investments in these instruments. The monthly reports of some hedge funds are beginning to find their way to investors right now. By the end of September, those that report on a quarterly basis, will also find their way to investors in early October. So we are entering a period where the extent of exposure and the potential destruction of value, will gradually become revealed. That is why we cannot say today that the crisis is over û that the damage is known, and that we can all rest easy. Virtually all crises are defined by the ultimate collapse or involuntary sale of financial institutions. In the mild crises it is the small intermediaries at the fringe of the market; but in the more material crises, it is the big players, such as LTCM in 1998.
The message of our book is that investors should be canny and careful, and take little for granted. My own strategy is to invest in sound assets and simply hold onto them. ThatÆs because the other relevant phenomenon about crises, is the system ultimately recovers. If you have the staying power, you will probably do fine.
In the crisis of 1907, was there a recession that followed?
Yes, there was a sharp recession, which Milton Friedman calls one of the five worst in the history of the US. It resulted in a high rate of unemployment. But it was for a rather brief period.
Using your analogy of a virus, you think the patient needs to go to bed, fight the fever and gradually recuperate? That is to say, you think there should be a recession to clean the system of its past excesses?
We never wish for recessions, as they impose great pain on the average man and woman. But the correction is part of the way in which markets move funds to poor investments and poor former decisions, and reallocate them to more productive uses. We need that correction process to occur.
This is the first major financial crisis that has happened in a disintermediated financial system. Do you think it will be worse or better than previous crises as a result? Is it a more dangerous world because of the disintermediation or should the crisis be more benign by spreading the risk?
It should be of great concern that the run on the bank û such as it is û is occurring in the shadow market. We know very little about the safety and soundness of the off balance sheet vehicles that have bought much of the subprime paper. ThatÆs why I hold we are in a very delicate period for the next few weeks. In the coming weeks more will be revealed.
The fact that we donÆt know. The fact there is this lack of transparency, is in itself, a great concern.
Heading for the exits is what happened through much of August. But it is only in the next few weeks we will really know how worried we should be about this crisis.
You have used analogies of hurricanes and viruses. But at this current juncture û this inflexion point û is it also like a game of blackjack where you have drawn 14, and cannot decide to stick or to draw another card? After all, many investors donÆt know which way things are going to go.
The wagering metaphor is quite apt. What has become clear is that the variance of the possible future scenarios is much wider than sophisticated investors thought just six weeks ago. So whether or not to take that card, could lead to dramatic consequences.
IÆll give you one more metaphor. Imagine the financial system as a giant pool table with many balls. Someone sets in motion one ball at great velocity. Some balls get hit, some end up in pockets and leave the game. What we are in the process of watching is a similar volatile situation in the markets. We should be concerned at this stage, particularly about entities that are less well known such as hedge funds and off balance sheet vehicles. What if all the balls gain velocity and create more collisions?
This is what the regulators and financial authorities are trying to avoid. But they donÆt have many instruments with which to fight the crisis. The Fed has already opened the discount window and is jawboning a great deal. The next element is to lower the Fed funds rate. But there isnÆt a lot more in the arsenal.
So has the increasing complexity of the financial system û a trend that has been ongoing since the 1980s û made the financial system stronger or weaker? Has it made the system more vulnerable to crises?
In 100 years we will judge that it is stronger. There is great gravity and magnetic pull at the centre of the system. The argument I am making is that the wings or tails of the distribution are where we should be cautious. The gravitational centre of the system will hold the wings in place û weÆll muddle through it. The issue is: with how much pain, and over what timeframe, and what disruption to the real economy. Those are the trillion dollar questions.
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