All epoch-defining events are the result of conjunctures – the correlation of normally unconnected events that jolt humanity out of a rut. Such conjunctures create what the author Nassim Nicholas Taleb calls “Black Swans” – unpredictable events with a vast impact. A small number of Black Swans, Taleb believes, “explain almost everything in our world.”
The prosperity of the first age of globalization before 1914, for example, resulted from a successful constellation of developments: falling transport and communication costs, the technological breakthroughs of the second industrial revolution, the pacific state of international relations, and Great Britain’s successful management of the gold standard. By contrast, in the interwar years poisonous international politics combined with global economic imbalances to create the Great Depression and set the scene for World War II.
Now consider recent financial innovations. On the back of the new computer and telecommunications technology, a giant market for derivative instruments was built. Collateralized debt obligations (CDOs, mainly tied to mortgages) made a new population of aspiring homeowners supposedly creditworthy by enabling the originating banks to sell “sub-prime” debt to other investors.
Before securitization, banks typically held mortgages; now they could get them off their books. But securitized credit taken off one bank’s balance sheet usually ended up on another bank’s books. What resulted was a wonderful system for diversifying individual bank risk, but only by magnifying the default risk of all banks that held what came to be called “toxic” debt. Because all the derivatives were based on the same assets, if anything happened to those assets, all the banks holding the debt would find themselves in the same soup.
What made the spread of derivatives possible was the ease with which the volume of debt for a given set of real assets could be expanded. This scalability was magnified by the use of credit default swaps (CDSs), which offered phony insurance against default. Since an unlimited number of CDSs could be sold against each borrower, the supply of swaps could grow much faster than the supply of bonds.
CDSs magnified the size of the bubble by hugely speeding up the velocity of monetary circulation. The CDO market grew from $275 billion to $4.7 trillion from 2000 to 2006, whereas the CDS market grew four times faster, from $920 billion in 2001 to $62 trillion by the end of 2007.
CDSs were the means by which derivatives found their way into the portfolios of banks all over the world. But the dependence of the whole structure on continually rising house prices was rarely made explicit. If the housing market started to fail, these paper assurances of safety would become, in Warren Buffett’s words, “financial weapons of mass destruction.”
But financial intermediation would never have brought disaster (or indeed gone so far) save for the global imbalances arising from America’s twin trade and budget deficits, financed to a large extent by Chinese savings. Floating exchange rates were supposed to prevent countries from manipulating their currencies, but, by accumulating large quantities of US treasury bills, East Asian countries, especially China, kept their exchange rates artificially low. This East Asian “savings glut” enabled a debt-fuelled consumption glut in the US, Britain, and much of the Western world.
But the marriage between Chinese savings and American consumption had a fatal flaw: it created non-repayable debts. Chinese investments increasingly took the form of official purchases of US Treasury bills. These investments did not create new resources to provide the means of repayment. For the counterpart of the US debt build-up was the relocation of much American manufacturing capacity to China. Chinese savings flowed not into creating new assets, but into financial speculation and consumer binges.
“Surplus” Chinese savings made possible America’s credit expansion between 2003-2005, when the federal funds rate (the overnight rate at which US banks lend to one another) was held at 1%. Ultra-cheap money produced a surge in sub-prime mortgage lending – a market that collapsed when interest rates increased steadily after 2005, reaching 5%.The financial crisis of 2008 was the start of a highly painful, but inevitable, process of de-leveraging.
This interpretation of the origins of the present slump is disputed by the ‘money glut’ school. In their view, there was one cause, and one cause only of the crisis: the excessive credit creation that took place when Alan Greenspan was chairman of the US Federal Reserve.
This view draws on the ‘Austrian’ theory of booms and slumps, and also Milton Friedman’s explanation of the Great Depression of 1929. It was wrong then, and it is wrong now.
This line of reasoning assumes that markets are perfectly efficient. If they go wrong, it must be because of mistakes in policy. This view is also self-contradictory, for if market participants are perfectly rational and perfectly informed, they would not have been fooled by a policy of making money cheaper than it really was. Greenspan is the sacrifice they offer to the god of the market.
This suggests a more fundamental reason for the economic crisis: the dominance of the Chicago school of economics, with its belief in the self-regulating properties of unfettered markets. This belief justified, or rationalized, the de-regulation of financial markets in the name of the so called “efficient-market hypothesis.” It led directly to the spread of financial risk-management models, which, by excluding the possibility of default, grossly underestimated the amount of risk in the system.
If we are going pursue the blame game, I blame economists more than bankers for the crisis. They established the system of ideas that bankers, politicians, and regulators applied.
John Maynard Keynes wrote that “practical men who believe themselves to be quite immune from intellectual influences are usually the slaves of some defunct economist.” Most of today’s crop of economists are not defunct, but continue to work in the ideological vicinity of Chicago. Their assumptions should be ruthlessly exposed, for they have come close to destroying our world.