Today’s financial crisis, triggered by the collapse of the housing bubble in the United States, also marks the end of an era of credit expansion based on the dollar as the international reserve currency. It is a much bigger storm than any that has occurred since the end of World War II.
To understand what is happening, we need a new paradigm. It is available in the theory of reflexivity, which I first proposed 20 years ago in my book The Alchemy of Finance . The theory holds that financial markets do not tend towards equilibrium. Biased views and misconceptions among market participants introduce uncertainty and unpredictability not only into market prices, but also into the fundamentals that those prices are supposed to reflect. Left to their own devices, markets are prone to extremes of euphoria and despair.
Indeed, because of their potential instability, financial markets are not left to their own devices; they are in the charge of authorities whose job it is to keep the excesses within bounds. But the authorities are also human and subject to biased views and misconceptions. And the interaction between financial markets and financial authorities is also reflexive.
Boom-bust processes usually revolve around credit, and always involve a bias or misconception – usually a failure to recognize a reflexive, circular connection between the willingness to lend and the value of the collateral. The recent US housing boom is a case in point.
But 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 know as moral hazard – which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former 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. This 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 globalized and the US began running a current account deficit. Since 1980, regulations have been progressively relaxed until they practically disappeared.
Globalization allowed the US to suck up the savings of the rest of the world and consume more than it produced, with its current account deficit reaching 6.2% of GNP 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.
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 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 collateralized 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. 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 World War II.
Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable. Moreover, 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 hoped 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 must recognize 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 interest rates were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. It is impossible to determine where that point is, but when it is reached, the Fed’s ability 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. As a result, 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 developing countries. The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession – or worse.