Sunday, January 27, 2008

The Current Financial Crisis: Causes and Lessons

On my 39th birthday this past Monday, I was greeted with a nearly 10% drop in the international stock indices that are highly correlated with my net worth. Fortunately, I’ve never put much stock in birthdays (no pun intended).

Since then markets in the U.S. and abroad have taken a roller coaster ride that is not for the timid. I don’t have statistics handy, but I wouldn’t be surprised if these past six months have been the most volatile in world financial markets since the Great Depression. It is an amazing time on trading floors everywhere.

Speculation, greed, outright fraud, and lax oversight of the lending and mortgage agencies have generated a degree of uncertainty and mistrust that is toxic to economic growth. The capitalist system relies on credit; when people are suspicious and don’t know who is a credit risk and who isn’t, things can grind to a halt. This is why the Federal Reserve and other central banks have been injecting billions into the global economy.

Will the United States fall into a recession? Although my crystal ball is in the repair shop, I think if we have one it won’t be severe. U.S. economic statistics have been sending mixed signals: there’s evidence of a slowdown, but no negative growth as yet. The good news is that many developing countries are sitting on trillions of dollars of reserves, and their economies are still expanding at a rapid pace. Oil prices are likely to moderate. As bad as the U.S. housing bubble was, I don’t think the hit on consumer spending will be enough to derail global economic growth. So if things do get ugly, you have proof of my Pollyanna nature right here.

As to the causes and lessons of all this, here are a few thoughts:

1. Alan Greenspan was a terrible Fed Chairman

I know this goes against conventional wisdom, but consider some facts. He provided political cover for tax cuts that have swollen the federal deficit; he took the Fed discount rate to historic lows and kept it there far longer than necessary, ignoring warnings about a housing bubble; in the midst of a run-up in home prices that was clearly unsustainable, he even urged people to take out adjustable rate mortgages instead of conventional fixed rate loans. Greenspan’s behavior lends credence to the view that the Federal Reserve has too much power, and that too often its power is used unwisely. In a genuinely free market, interest rates would never have remained so low for so long.

2. The bond rating agencies engaged in stupid (and possibly criminal) behavior

Hundreds of billions of dollars of bonds comprised of the mortgages of low income people who could not afford their homes were falsely rated “AAA”. This is negligence on a scale not seen since the savings and loan debacle.

3. That being said, what happened to the “wisdom of the market”?

The logic of the “invisible hand” in financial markets is that huge sums of money create equally huge incentives both for fraud and its detection. Were the rating agencies in bed with the banks making the mortgages? What about the institutions that bought the bonds: how were they so easily deceived with so much on the line? Where was the oversight and regulation when it was needed? This is big-time egg on the face of those who preach the wonders of markets; things like this simply aren’t supposed to happen, especially on such a grand scale.

4. How inter-connected is the world financial system?

We’re about to find out. You may have heard the term “decoupling” a few times over the past week. It refers to the idea that foreign economies may no longer be as dependent on exports to the U.S. as they once were. The link between fears of a U.S. recession and plunges in overseas stock markets led many this week to pronounce an end to the decoupling theory. This is premature: the theory never assumed complete decoupling, only a decrease in the influence of the U.S market. I think the decoupling idea is sound, and that a mild U.S. recession will not have a major impact on foreign economies, especially those in emerging countries.

Final thought. One silver lining from the burst in the housing bubble is that no longer do I have to endure people bragging about what financial geniuses they were to buy real estate in California at inflated prices. Thankfully I was saved from having to eat that very expensive piece of humble pie.

Jason Scorse

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