Monday, September 15, 2008

On Financial Meltdowns

Frederick Bastiat, the nineteenth century French economist, once authored a memorable essay aptly titled 'What is Seen and What is not Seen' in which he said that the unintended, often invisible consequences of an event tend to be overshadowed by the more obvious effects. We are so preoccupied with the visible problems resulting from an event that we completely overlook the much more darker possibilities that might have unfolded had the event not happened.

The current financial meltdown is a classic example. Large, hitherto formidable, investment banks have succumbed, marking what's clearly the worst financial crisis in atleast a generation. Pundits of all hues have been quick to demonise financial innovation (read CDOs and derivatives) as the prime culprit. However such an inference is incorrect since it is based on the faulty assumption that there would have been no crisis in the absence of the much maligned financial products.

The seeds of the current crisis were sown by the discretionary monetary policy of the Federal Reserve which kept interest rates too low for too long by overreacting to the economic slowdown in 2001. The fact that Asian central banks were propping up the dollar and suppressing long-term interest rates by investing in American bonds did not help matters. The abundance of liquidity and the availability of easy money triggered a huge demand for credit among those who had hitherto not entertained notions of taking on debt and successfully servicing it. When the rates eventually started increasing circa 2005, defaults started piling up and the banks had to face the music.

Now, all of this would have happened regardless of the sophistication of the financial products in place. Securitization is essentially a tool for managing risk. No...it doesn't help us get rid of risk. But it ensures that the risk is borne by those who are most capable of bearing it. Imagine a world without securitization and derivatives. A more traditional world where banks borrow short from depositors and lend long to individuals and businesses. In the event of widespread defaults, the risk would be borne by those who are least capable of bearing it - the small time depositor, the average Joe on the street who has placed all his lifetime savings in the neighbourhood bank. Bank runs would have ensued thus contracting the money supply in the economy. What's worse, many depositors would've lost savings of a lifetime. This is precisely what happened in the early thirties during the Great Depression. The amount of money in the economy declined remarkably and the size of the economy shrunk by almost a third in a couple of years!

Thanks to securitization and the widespread use of derivatives, bank runs are now a thing of the past. The real economy continues to grow at a reasonable rate despite the carnage in the financial sector. Yes, there will be job losses resulting from bankruptcies. But the ones affected belong to the highly skilled, educated and affluent section of the workforce who are extremely employable and can afford to make ends meet without a job for a few months atleast.

Commentators who cannot look beyond the obvious claim that the current crisis is an indictment of free markets and financial innovation. They cannot be more wrong. The crisis is infact reason enough for us to celebrate the virtues of financial innovation, which have helped insulate the real economy and also ensured that the risk is NOT borne by the more vulnerable sections of society.

Postscript :
Bank runs are now a part of our economic mythology - a curiosity from a bygone era that can only be recreated in movies. Here's a clip from the classic Frank Capra film, It's a Wonderful Life that illustrates a bank run :)


"..it ensures that risk is borne by those most capable of bearing it."

Perhaps "..it ensures that risk is borne by those most willing to bear it(at the asking price)."

There may be a "complexity effect" in recovering from system malfunctions e.g. see Baden Eunson's review of "Normal Accidents" Charles Perrow, Basic Books,1984.

e.g. “Most [systems] can be understood in terms of two dimensions, complexity and coupling."
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