- LOGIN
- |
- REGISTER
- |
- RSS
- |
- IU IN THE NEWS
- |
- ABOUT US
- |
- CONTACT
- |
- IndexUniverse.eu
Articles
 Gauging the current credit crisisThe financial markets remain mired in a series of credit crunches and disruptions that began about a year ago when it became clear home prices wouldn't rise forever and that some mortgage lenders and borrowers were a bit too optimistic about how soon (formerly) rising prices would bail them out. The spreading credit difficulties seem to puzzle a lot of market participants, as though it were unprecedented. But it has happened before, although in slightly different disguises each time. Maybe the best evidence that we've all been through this are the titles of those books we now wish we'd actually read. These might begin with Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds from 1841, recounting, among other events, the Dutch tulip craze of 1637. For those who missed that crisis, dealing in futures on tulip bulbs got a bit out of hand as prize bulbs sold for more than houses. Then the market collapsed as the delusions and madness became clear. Holland suffered a recession. Tulip bulbs were only the most infamous example Mackay chronicled; there was also John Law's banking games in France and Britain's South Sea Bubble. More recent and more analytical is Charles Kindleberger's Manias, Panics, and Crashes, now in its fifth edition. Kindleberger, a well-known economic historian, passed away in 2003. He recognized that there is a regular pattern to financial mania beginning with some shift or event that leads to a seemingly unprecedented boom. For the current boom, it was the Fed's long-running effort to stave off recession after the dot-bomb bust. The Fed's extended period of very low interest rates succeeded at that goal, but it set the stage for the housing boom and current bust. As the housing boom got going, everyone had a reason why home prices would not fall, and even why a doubling of home prices since 2000 made perfect sense. Few cared to look back to 1990–91 when home prices, also spurred by cheap money (in the aftermath of the S&L bailout), fell. By the time things were really rolling along—late 2006 and the early beginnings of 2007—one could point to what Robert Shiller titled the second edition of his famous book, Irrational Exuberance, about buying a home. (Or, in some cases, buying several homes as an investment.) As Kindleberger and others remind us, after the mania comes the panic and crash. Indeed, that's about where we are now. As the market turmoil has spread from market to market, many still seem puzzled. Why, as a new market is struck, do people still rush for cash? This pattern was also seen before. When a credit crunch starts, would-be borrowers ask themselves whether they would like to hold on to the bank's commitment to lend or if they would prefer cold cash. It doesn't take much to prefer cash, especially when the sky is falling. As the crunch begins, anyone with a line of credit or a commercial paper program promptly draws it down. In a crisis, cash is king. But this leaves the lenders without cash—the borrowers have it all. In response, the lenders raise interest rates and tighten credit standards and the crunch worsens. While solvency is enough to assure a loan in good times, liquidity is the only thing that matters in times like these. There is another shift as credit tightens and markets slide— risk becomes a four-letter word. In good times, everyone willingly takes on risk. In very good times, no one even believes in risk—higher volatility is seen as a sure path to much higher returns. But when the crunch comes, everyone runs from risk and the markets can find no takers, even as prices fall. The economy rapidly moves from a high-growth/high-investment posture where risk-taking is widespread, to a deep funk where the only thing anyone will hold is cash. If this pattern is not interrupted, recession and slumping investment are the result. The shifts in attitudes toward risk are of much greater magnitude than the shifts in economic growth, employment or profits. The changed appetite for risk magnifies the damage from the crash. To a large extent, the goal of Fed rate cuts is to reawaken risk-taking, not to trim the cost of money. However, at times the Fed does too good a job at reawakening risk-taking. The aftermath of the dot-bomb bust may have been one of those times. Hyman Minsky, an economist of the second half of the 20th century who studied these concerns, pointed out that stability is, itself, destabilizing. In long periods of stability, the market comes to believe that there are few dangers, that markets will always rebound and that we will always come out ahead and profitable. Many who experienced the markets of the 1980s and 1990s enjoyed such a period of stability. Yes, there was a crash in 1987 and there were falling home prices in 1990-–91, but we survived and prospered through all of that and much more. We can smile and tell tales of the S&L Crisis, of Long-Term Capital Management, of The Asian Crisis and Russia's Debt Default. Most of all, we can all tell tales of the Age of Greenspan when the Fed seemed capable of fixing anything. Many of us forgot that the opening of the period of stability actually came before the Age of Greenspan. In 1979, President Carter appointed a little-known banker, Paul Volcker, to run the Fed. Volcker looked around and saw double-digit inflation threatening the economy. He set out to vanquish inflation, no matter what. He did, but at the cost of two back-to-back recessions with double-digit unemployment and interest rates twice as high as the 10-percent-plus unemployment rate. The pain was terrible but the cure was worth it—two decades of rising markets and booming economies in the Age of Greenspan. There are two questions facing the markets now, one partially academic and one far more serious. The academic one is whether this is a "Minsky Moment" when the past stability bred excess and collapse. Maybe the question is not if, but how bad. The second is the question that faces the Fed—is recession or inflation the more likely and more pressing problem? If the answer is recession, that's almost good for our economy as a whole. Usually, fighting recession is ultimately successful: It means lower interest rates and markets tend to rebound early in the battle. At this writing, the Fed is fighting recession and is cutting interest rates. However, not quite everyone is convinced, and that old love of risk is not yet back in style. If the enemy is inflation, things are less attractive. Volcker's cure was high interest rates and a nasty recession to wring out inflation. It's no fun and markets fall further before any discussion of recovery. If inflation is the enemy, the Fed will need to reverse course. Is fighting inflation worth it? The successful economic policy of the 1980s and 1990s—for both political parties— could be summed up as follows: The Fed takes care of controlling inflation and the economy takes care of itself and just about everything else. Time will tell which battle— inflation or recession—will be the battle of 2008. |
© Copyright IndexUniverse.com 2008, All rights reserved. Permalink
