Bill Emmott - International Author & Adviser


Hype about the credit crunch
Exame - March 2008

If you judge economic affairs according to the movements of financial markets, these are dramatic times. The collapse and rescue of Bear Stearns, America’s fifth-largest investment bank, over the period of March 15-24 was the culmination of eight volatile months in global markets, but just set off even more unsettling movements in equities, currencies, debt, gold, oil and commodities. Yet all this drama still leaves us with two unanswered questions: first, what does all this really mean for the global economy? And, second, might the greater role we are seeing for intervention by the Federal Reserve and other central banks be the beginning of a new period of tighter regulation and closer government control?

            The second of those questions is actually the more profound one. But let us briefly address the first one, as that feels more immediately important to most readers’ lives. The answer to it is that we are right to be worried about global economic growth and stability, but that so far there is no reason to believe that we are going to see the dramas in financial markets reflected in dramatic economic consequences. Talk by Alan Greenspan, former chairman of the Fed, in the Financial Times on March 15th that America could now see its worst recession since the second world war looks way overblown.

            Before believing such panicky talk, it is as well to remember just what a good situation the world economy is in. America may be technically in recession, but its unemployment rate in February remained at only 4.8% of its workforce, which is roughly half the level it reached during the recessions of the 1980s and early 90s. Inflation has jumped, thanks to dearer food and energy, but the worry is about inflation at 4% in America—again, relatively nice problems to have compared with the last time we were all writing about recessions, hyperinflation and house-price collapses.

            Then, if we look beyond the Atlantic, the world economy as a whole has been expanding more rapidly during the past four years than at any time since the 1960s, with growth led by China and India but also shared widely across Africa, Latin America, the Middle East and Eastern Europe. That is precisely why inflation is a worry: demand for food, energy and other commodities has been soaring. Indeed, until the credit crunch hit last August, the fashionable worry was of too much growth—because of global warming—not too little.

            In fact, what has been happening so far, as America has slowed and then begun to contract, is the same necessary adjustment both in the American and the global economies that economists have been calling for during the past five years. Economic pundits have been saying that credit had become too easy, that house prices had risen too high, that the dollar needed to fall, that financiers had been making too much money, that the world had become too unbalanced between the trade deficit countries around the Atlantic and the surplus-producers in Asia. Now those pendulums are swinging back—which is surely good news, not bad.

            It could, admittedly, become much worse news if the banks’ evident loss of faith in each other as borrowers extends to a loss of faith in ordinary companies and consumers. The credit boom in recent years was primarily a boom in lending and borrowing between financial firms—banks, hedge funds, private equity and more—using ever fancier bits of paper, which spilled over into reckless and sometimes fraudulent mortgage lending in America’s so-called “subprime” market. The collapse of Bear Stearns signals the end of that inter-bank credit boom. So far, however, there are few signs that this is leading to a sharp tightening of credit conditions in the real economy. But it could still happen.

            That is where the worry about a nasty recession contains some truth. But unless that tightening also brings big bank collapses, it is hard to see why it should be a severe one. At such times, consumers should all be trimming back their debts just in case they lose their jobs, a process which will itself slow the economy. But in America’s flexible and liquid markets, the process of writing-off losses and of dispensing with unrepayable debt is likely to be rapid—far more rapid than it was during Japan’s long deflationary stagnation during the 1990s. It will take place in a favourable international climate, with interest rates low and capital abundant in global markets thanks to Asia’s high savings rate.


A new regulatory era

It is the second question, about whether these financial dramas will mark the start of a new era of state intervention, that carries more weight and more truth. The answer is that it will, because it must. We will not again see such unregulated behaviour by financial firms as we have seen in recent years.

            Financial regulation, especially in the rich countries, has in recent decades focused on ensuring that commercial banks, which benefit from government protection of depositors and from borrowing privileges at central banks, keep sufficient capital aside as a cushion against the risks they are taking. What we have seen in the past year, however, is two big problems for this model: first, that banks have evaded these capital controls by pushing risks into special off-balance-sheet vehicles of the sort made notorious by Enron; second, that investment banks have become huge players in credit markets and are just as interconnected with each other as has traditionally been the case with commercial banks. So the failure of one big investment bank risks bringing down many others.

            These two problems have, so far, been met by one solution: extra support from central banks, offered not just to commercial banks but also to investment banks like Bear Stearns. The trouble with that, however, is that it imposes heavy costs on the taxpayer and it gives financiers a one-way bet, under which they get the rewards when they win but are bailed out when they lose.

            The central banks have been right to step in. But now they must insist that regulation should be tightened in the future. In return for protection and privileged borrowing facilities, central banks must now insist on greater control over what investment banks do with their borrowings. The case for such control would be even stronger if central banks decide to carry out the mass purchase of mortgage-backed securities they are said to be pondering.

            Investment banks in America need to be put under the same capital-adequacy controls as commercial banks, and the law must not allow any banks to circumvent such controls through off-balance-sheet vehicles. Moreover, consumer protection rules will have to be reviewed in order to prevent any repeat of the recklessness and fraud that has occurred in America’s subprime mortgage market.

            This change is easier described than done. It is hard to get capital-adequacy rules right, and hard in global markets to enforce them. Yet working on this task now looks increasingly urgent, for the regulators and supervisors in all the world’s principal financial centres. Innovation in finance has been of great benefit to the global economy. But when that innovation means taking ever bigger risks on the basis of small cushions of capital, then innovation has gone too far.                       


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