Credit and blame

tauringhuang.

Sep 11th 2008
From The Economist print edition

A must-read on the origins of the crisis

Illustration by S. KambayashiANOTHER week, another drama. The unveiling of the second bail-out plan for Fannie Mae and Freddie Mac on September 7th—to say nothing of the dwindling fortunes of Lehman Brothers in the succeeding days—was a reminder that the credit crunch is proving infuriatingly difficult to bring to an end.

The crunch has lasted long enough to spawn its own publishing mini-boom, as authors have raced to give their diagnoses in print. George Cooper, a strategist at JPMorgan, an investment bank, has produced by far the best so far*, skewering both academic orthodoxy and central-bank policy in the process.

The problem, says Mr Cooper, is that central banks have subscribed to one economic philosophy in an expanding economy and quite another when the economy is contracting. When things are going well, central banks leave the markets alone. But at the merest hint of crisis, central bankers have responded by cutting interest rates to stimulate their economies and prevent asset prices from falling. Tongue firmly in cheek, Mr Cooper describes this as “pre-emptive asymmetric monetary policy”.

This approach, he argues, stems from a belief in efficient-market theory which states, at its simplest, that prices reflect all available information. On that basis, asset prices are always “right”, there can be no bubbles and central banks should not intervene to restrain speculative excess. Similar reasoning seems to have persuaded Alan Greenspan, the former chairman of the Federal Reserve, not to prick the dotcom bubble of 1999, even after warning of “irrational exuberance” in 1996.

To be fair, Mr Greenspan did not argue that there were no bubbles, only that it was impossible to spot them while they were inflating. Instead, he felt that central banks should wait to mop up the mess once the bubble had burst.

In contrast, Mr Cooper argues that markets are far from efficient, as they often get locked into feedback mechanisms that lead to booms and busts. Indeed, if markets were really as efficient as some believe, why would economies need central banks in the first place? The market would set the appropriate level of interest rates for the economy and would automatically rebalance itself in the event of a problem in the financial system.

tauringhuang.

However, crises occur time and again, and far more frequently than most financial models would predict. Perhaps this is because investors are not the perfectly informed paragons found in efficient-market theory. Instead, they may simply be unable to get enough information to make correct judgments about the value of securities, or indeed may be given misleading information by insiders such as company executives or salesmen from the financial-services industry.

Central-bank intervention to prop up markets is often popular at the time; few people relish banking collapses or recessions. But it creates problems in the long run. The first is that consumers (and companies) are encouraged to borrow, not save, thanks to the low level of interest rates and a belief that central banks and governments will always rescue them if things go wrong. But as Mr Cooper writes: “A depressed savings rate leaves the economy precariously positioned to deal with future adverse shocks.”

The second danger is that the system becomes progressively less stable as risk-taking is encouraged. Instead, central banks should permit some short-term cyclicality in order to purge the system of excesses. They can do this, Mr Cooper argues, by preventing excessive credit creation (which he defines as credit growth far ahead of economic growth).

tauringhuang.

This is not a new thesis, as the author accepts. Hyman Minsky developed a theory of financial instability in the 1970s. Jeremiahs have been warning about a looming debt crisis for at least 20 years. But Mr Cooper’s book is by far the most cogent and reasoned of the modern-day “credit excess” school.

Alas, the author does not see an easy way out of today’s mess, in effect arguing that we “shouldn’t start from here”. Letting the markets have their way would risk a repeat of the 1930s, and the Fannie and Freddie rescue shows the authorities are desperate to avoid that. But the danger is that central banks inflate another credit bubble, saving the economy from disaster in the short term but raising the stakes still further when the next crisis comes around. The Fannie and Freddie rescue, though unavoidable, suggests the world is heading in that direction.



*“The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy”. Published by Harriman House.