Monday, 23 September 2013

Five years after the crisis: the legacy

Five years have passed since the collapse of Lehman Brothers and the subsequent devastating blow to the financial system in the US, and the consequential spillover of the panic to the rest of the world. Lehman's bankruptcy in September 2008 was one of those events that could have brought down the entire world financial system. Fortunately or unfortunately (for some) it didn't, but the damage was devastating and the consequences are still present. The recovery has been slow and painful, especially with respect to all other post-war recoveries. Some put the blame entirely on the policymakers, where they either didn't do enough, or did too much (where the unit of value is the size of the stimulus). After the massive fiscal stimuli applied in the US and in many European countries during the downturn, in 2010 after the US crisis was officially over according to NBER, austerity kicked in. Austerity came primarily as a reaction to the doubling or tripling of debt to GDP ratios in some countries, in addition to a rising budget deficit, all of which were caused mainly by huge bank bailouts. However, the austerity applied wasn't the austerity based on spending cuts and structural reforms, it was austerity based on tax hikes and little or no real spending cuts. The superficial spending cuts combined with many tax hikes (in order to close the deficit) missed their real targets - interest groups and government cronies whose vast political concessions were among the causes of the crisis in peripheral Eurozone. They were all left untouched. The only ones that really lost out were the taxpayers, either by losing their jobs, losing their incomes, or bailing out banks. 


Today, September 2013, is all about anniversary "celebrations". As I've pointed out in my last week's text, all the major papers, the Economist (Free exchange), Financial TimesWall Street JournalNew York TimesBloomberg and many others have had their take on the lessons and the consequences of the crisis, reminiscing of the shambles during the days of Lehman's bankruptcy. I too will make a contribution, following the prequel from last week on the the housing bubble initiated by Fannie Mae and Freddie Mac.

Understanding the causes 

Going through some of the so-called lessons, I can see that many people still haven't learned what the actual causes of the crisis were. Too many arguments today are still clouded by ideological backlash trying to blame it all on the "banksters" whose greed made them take in more risk in order to achieve higher profits, in addition to years of low inflation and low interest rates. For example, a serious economist simply cannot make a statement like this: "Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used the funds to buy dodgy securities." (this is coming from The Economist, btw). 

I would like to see the research paper making a causal inference between greed and the purchase of dodgy securities. I seriously doubt the consistency and credibility of such a paper. European banks didn't buy into securities that were dodgy. These securities didn't turn out to be dodgy until the crisis had already started. 

During the time of collapse the media was full of stories about how the banks' balance sheets were filled with risky investments and that this kind of profit-seeking behaviour was unacceptable. Particularly since it's not their money to gamble with. The Marxists were awaken. However, what they failed to realize was that the vast majority of banks' balance sheets were made of previously AAA rated securities which included things like Greek debt on one hand, and MBSs on the other. This varies across different countries however, but the point is that banks did apply a fairly good risk diversification, where only a small share of assets were those of high risk, while in some cases over 90% were AAA-rated MBSs. As the housing bubble burst most of those MBSs made from sub-prime mortgages became junk (toxic). This happened to Lehman for example. Its leverage ratio was 30:1 at the time of bankruptcy. For others it was panic as their loses started growing exponentially. All of a sudden everyone realized that the entire system is inherently unstable. Investors panicked, and the rest is history. 

There is no doubt that the bankers had a big role in risk taking and there is no doubt they take a large share of the blame, but in order to get the big picture we need to understand the underlying factors a bit better. The crucial problem with the system at hand was the idea that risk can be eliminated. This is a huge fallacy and both the regulators and the bankers have succumbed to it. As the regulators were steering banks into "safe" assets like Greek debt or sub-prime mortgages, the bankers were foolish enough to believe that these assets were in fact safe (i.e. risk-free). There is no such thing as a zero-risk investment. Hopefully, we have learned that by now.  

Lessons, implications and open questions

The legacy of the crisis is a multitude of open questions and many opposing views as to what are the correct answers. First of all, there is the issue of justifying the bailouts. Their initiation is the key reason behind the sovereign debt crisis in Europe and debt sustainability in America. However many claim that their existence is justified as they helped prevent the panic of Lehman crash turning into another Great Depression. 

In retrospect, the clear market signal at the time was that the current patterns of production, specialization and trade have reached a point where change was necessary. This is why the recovery is lasting for so long. The market forces simply weren't allowed to restructure and point out to the new equilibrium in pre-crisis times. As things were going well and profits were rising, there was no question of interfering into the structural factors behind the rapid growth. In other words, there was no incentive to respond to the technological shocks and new market trends such as outsourcing. As the crisis started all of these problems suddenly surfaced and became evident to everyone. Except now it was too late for a gradual adjustment on the labour market. The adjustment came immediately, causing many people to lose their jobs. Currently the slow state of the recovery is in some way due to the slow process of adjustment by the firms and the demand for skills to the new equilibrium. This process will last even longer as governments are pushing it back, subject to increasing pressure from all those that are likely to lose out - such as public sector labour unions and workers in declining industries. 

The third issue is the safety of the global financial system. Are new regulations going to make the system safer than before? Isn't this exactly what pre-crisis regulation was aiming to do? Via Basel standards? Isn't it paradoxical that pre-crisis regulators whose sole purpose was to eliminate risk proved out to be the largest culprit in the crisis by encouraging banks to fill up their assets with MBSs or sovereign debt? With the pre-crisis system working perfectly according to many actors at the time, how do we know that new capital standards will do the trick today? Particularly if the regulators again try to steer bank asset into safer investments. I'm not saying regulators willingly do these kinds of things. They actually strive for the opposite. While they were recognizing MBSs as safe assets and encouraging banks to purchase them, they were under the impression this would help the system. But that's exactly the point. By striving to make the system stable, the regulators end up increasing systemic risk and fueling artificial demand that results in asset bubbles. By creating incentives to invest in certain types of assets, the regulators send distorted signals about the demand for these assets and hence distort its prices. They became victims of the asymmetry of information. 

Some countries had it even worse, where in addition to global forces and regulatory omissions, domestic political cronyism got involved. Spain for example had their political elites orchestrating regional banks' investments into politically favored projects, thus fueling the housing bubble. Others like Greece or Italy had political concessions cramp the welfare state. The stage for their collapse was set years before the actual crisis had started. Who can protect them from future failures? The current mechanism of the Eurozone has not only failed to prevent it, the introduction of the euro actually encouraged their instabilities

According to this another thing the crisis has taught us is that investors and banks can never be too careful. Especially when investing into sovereign debt, and when they blindly follow regulations. As for the euro, by now it's obvious to everyone it is irreversible, and that there will always be forces aiming to preserve it. This makes it a safe investment doesn't it? 

Finally, will crises like this one be possible in the future? Absolutely. Perhaps not in the same way and perhaps not that soon, but they are certainly possible. Accumulation of debt and high investments during good times, in combination with an artificial demand for assets causes booms and busts that congest the system. If this happens in the same time as a technological shock that changes the patterns of production and labour market specialization, then the bust becomes larger and the asset boom spreads across the real sector of the economy. The economy slowly and painfully grabs towards a new equilibrium, while during the process many of the ideological battlegrounds of economic theory reinvent themselves all over again. 

2 comments:

  1. As I said before the crash was caused by a classic easy credit bubble. In this case easy credit and loose money in the real estate sector but also extensive margins on new styles of securities. (also something that happens in most bubbles). Government was not the sole culprit but governments certainly added fuel to the fire.

    Then, the response to the crisis was also classic in that it was an overreaction which actually hindered recovery.

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  2. Great analysis! I agree that it's hard to justify the bailouts and I strongly agree with your concerns on the safety of the financial system. If they believed the system was so solvent and well capitalized before the crash, then how can they be sure of anything that comes as a response? Regulation is always lagging, it can only address the problems we had before, but can never really solve future issues

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