The current http://www.ft.com/cms/s/0/604d71dc-c853-11dc-94a6-0000779fd2ac,dwp_uuid=d355f29c-d238-11db-a7c0-000b5df10621.html - financial crisis
was precipitated by a bubble in the US housing market. In some ways it
resembles other crises that have occurred since the end of the second
world war at intervals ranging from four to 10 years.
However,
there is a profound difference: the current crisis marks the end of an
era of credit expansion based on the dollar as the international
reserve currency. The periodic crises were part of a larger boom-bust
process. The current crisis is the culmination of a super-boom that has
lasted for more than 60 years.
Boom-bust processes usually
revolve around credit and always involve a bias or misconception. This
is usually a failure to recognise a reflexive, circular connection
between the willingness to lend and the value of the collateral. Ease
of credit generates demand that pushes up the value of property, which
in turn increases the amount of credit available. A bubble starts when
people buy houses in the expectation that they can refinance their
mortgages at a profit. The recent US housing boom is a case in point.
The 60-year super-boom is a more complicated case.
Every time the
credit expansion ran into trouble the financial authorities intervened,
injecting liquidity and finding other ways to stimulate the economy.
That created a system of asymmetric incentives also known as moral
hazard, which encouraged ever greater credit expansion. The system was
so successful that people came to believe in what former US president
Ronald Reagan called the magic of the marketplace and I call market
fundamentalism. Fundamentalists believe that markets tend towards
equilibrium and the common interest is best served by allowing
participants to pursue their self-interest. It is an obvious
misconception, because it was the intervention of the authorities that
prevented financial markets from breaking down, not the markets
themselves. Nevertheless, market fundamentalism emerged as the dominant
ideology in the 1980s, when financial markets started to become
globalised and the US started to run a current account deficit.
Globalisation
allowed the US to suck up the savings of the rest of the world and
consume more than it produced. The US current account deficit reached
6.2 per cent of gross national product in 2006. The financial markets
encouraged consumers to borrow by introducing ever more sophisticated
instruments and more generous terms. The authorities aided and abetted
the process by intervening whenever the global financial system was at
risk. Since 1980, regulations have been progressively relaxed until
they have practically disappeared.
The super-boom got out of hand
when the new products became so complicated that the authorities could
no longer calculate the risks and started relying on the risk
management methods of the banks themselves. Similarly, the rating
agencies relied on the information provided by the originators of
synthetic products. It was a shocking abdication of responsibility.
Everything
that could go wrong did. What started with subprime mortgages spread to
all collateralised debt obligations, endangered municipal and mortgage
insurance and reinsurance companies and threatened to unravel the
multi-trillion-dollar credit default swap market. Investment banks’
commitments to leveraged buyouts became liabilities. Market-neutral
hedge funds turned out not to be market-neutral and had to be unwound.
The asset-backed commercial paper market came to a standstill and the
special investment vehicles set up by banks to get mortgages off their
balance sheets could no longer get outside financing. The final blow
came when interbank lending, which is at the heart of the financial
system, was disrupted because banks had to husband their resources and
could not trust their counterparties. The central banks had to inject
an unprecedented amount of money and extend credit on an unprecedented
range of securities to a broader range of institutions than ever
before. That made the crisis more severe than any since the second
world war.
Credit expansion must now be followed by a period of
contraction, because some of the new credit instruments and practices
are unsound and unsustainable. The ability of the financial authorities
to stimulate the economy is constrained by the unwillingness of the
rest of the world to accumulate additional dollar reserves. Until
recently, investors were hoping that the US Federal Reserve would do
whatever it takes to avoid a recession, because that is what it did on
previous occasions. Now they will have to realise that the Fed may no
longer be in a position to do so. With oil, food and other commodities
firm, and the renminbi appreciating somewhat faster, the Fed also has
to worry about inflation. If federal funds were lowered beyond a
certain point, the dollar would come under renewed pressure and
long-term bonds would actually go up in yield. Where that point is, is
impossible to determine. When it is reached, the ability of the Fed to
stimulate the economy comes to an end.
Although a recession in
the developed world is now more or less inevitable, China, India and
some of the oil-producing countries are in a very strong countertrend.
So, the current financial crisis is less likely to cause a global
recession than a radical realignment of the global economy, with a
relative decline of the US and the rise of China and other countries in
the developing world.
The danger is that the resulting
political tensions, including US protectionism, may disrupt the global
economy and plunge the world into recession or worse.
The writer is chairman of Soros Fund Management