The financial turmoil is like an elephant in a dark room

By Martin Wolf, Financial Times, January 22 2008

Pinn illustration

“I was gradually coming to believe that the US economy’s greatest strength was its resiliency – its ability to absorb disruptions and recover, often in ways and at a pace you’d never be able to predict, much less dictate.” Alan Greenspan, ‘The Age of Turbulence’.

We all hope that Mr Greenspan proves right about the US economy. The Federal Reserve’s rate cut on Tuesday will succeed if Mr Greenspan’s view is correct. Yet many fear he is wrong. Many, too, blame him for the current mess. So how did the world economy fall into its predicament?

One view is that this crisis is a product of a fundamentally defective financial system. An email I received this week laid out the charge: the crisis, it asserted, is the product of “greedy, immoral, solely self-interested and self-delusional decisions made throughout the 2000s, and earlier, by very real human beings at the very top of the financial food chain”.

The argument would be that a liberalised financial system, which offers opportunities for extraordinary profits, has a parallel capacity for generating self-feeding mistakes. The story is familiar: financial innovation and an enthusiasm for risk-taking generate rapid increases in credit, which drive up asset prices, thereby justifying still more credit expansion and yet higher asset prices. Then comes a top to asset prices, panic selling, a credit freeze, mass insolvency and recession. An unregulated credit system, then, is inherently unstable and destabilising.

This is the line of argument associated with the late Hyman Minsky, who taught at Washington University, St Louis. George Magnus of UBS distinguished himself by arguing early that the present crisis is a “Minsky moment”: “A collapse of debt structures and entities in the wake of asset price decay, the breakdown of ‘normal’ banking functions and the active intervention of central banks”. This follows an extraordinary dependence on credit growth in the recent cycle (see chart).

Economists would offer contrasting explanations for this fragility. One is in terms of rational responses to incentives. Another is in terms of the short-sightedness of human beings. The contrast is between misdirected intelligence and folly.

US economy

Those who emphasise rationality can readily point to the incentives for the financial sector to take undue risk. This is the result of the interaction of “asymmetric information” – the fact that insiders know more than anybody else what is going on – with “moral hazard” – the perception that the government will rescue financial institutions if enough of them fall into difficulty at the same time. There is evident truth in both propositions: if, for example, the UK government feels obliged to rescue a modest-sized mortgage bank, such as Northern Rock, moral hazard is rife.

Yet it is also evident that everybody involved – borrowers, lenders and regulators – can be swept away in tides of all-too-human euphoria and panic. To err is human. That is one of the reasons regulation is rarely countercyclical: regulators can be swept away, as well. The financial deregulation and securitisation of the most recent cycle merely encouraged an unusually wide circle of people to believe they would be winners, while somebody else would bear the risks and, ultimately, the costs.

Yet there is a different perspective. The argument here is that US monetary policy was too loose for too long after the collapse of the Wall Street bubble in 2000 and the terrorist outrage of September 11 2001. This critique is widely shared among economists, including John Taylor of Stanford University.* The view is also popular in financial markets: “It isn’t our fault; it’s the fault of Alan Greenspan, the ‘serial bubble blower’.”

The argument that the crisis is the product of a gross monetary disorder has three variants: the orthodox view is simply that a mistake was made; a slightly less orthodox view is that the mistake was intellectual – the Fed’s determination to ignore asset prices in the formation of monetary policy; a still less orthodox view is that man-made (fiat) money is inherently unstable. All will then be solved when, as Mr Greenspan himself believed, the world goes back on to gold. Human beings must, like Odysseus, be chained to the mast of gold if they are to avoid repeated monetary shipwrecks.

Economy charts

A final perspective is that the crisis is the consequence neither of financial fragility nor of mistakes by important central banks. It is the result of global macroeconomic disorder, particularly the massive flows of surplus capital from Asian emerging economies (notably China), oil exporters and a few high-income countries and, in addition, the financial surpluses of the corporate sectors of many countries.

In this perspective, central banks and so financial markets were merely reacting to the global economic environment. Surplus savings meant not only low real interest rates, but a need to generate high levels of offsetting demand in capital-importing countries, of which the US was much the most important.

In this view (which I share) the Fed could have avoided pursuing what seem like excessively expansionary monetary policies only if it had been willing to accept a prolonged recession, possibly a slump. But it had neither the desire nor, indeed, the mandate to allow any such thing. The Fed’s dilemma then was that the only way to sustain domestic demand at levels high enough to offset the capital inflow (both private and official) was via a credit boom. This generated excessively high asset prices, particularly in housing. It has left, as a painful legacy, stretched balance sheets in both the non-financial and financial sectors: debt deflation, here, alas, we come.

When I read these analyses, I am reminded of the story in which four people are told to go into a dark room, hold on to whatever they find and then say what it is. One says it is a snake. Another says it is a leathery sail. A third says it is a tree trunk. The last says it is a pull rope.

It is, of course, an elephant. The truth is that an accurate story would be a combination of the various elements. Global macroeconomic imbalances played a huge part in driving monetary policy decisions. These, in turn, led to house-price bubbles and huge financial excesses, particularly in securitised assets. Now policymakers are forced to deal with today’s symptoms as best they can. But they must also tackle the underlying causes if further huge disturbances are not to come along. What those responses should ideally be at both national and global levels will be the subject of my post-World Economic Forum column next week.

*Housing and Monetary Policy, September 1 2007,


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