Suddenly all talk is of financial and ‘economic’ crisis. Being an economist I am repeatedly being asked for my views on this recent turn of events. I’m not an expert in this area so I’m rather hesitant to give an opinion: my instinctive response is to point out that if I really knew what was going to happen next a) I’d be (or about to be) a very rich man b) I probably wouldn’t be telling them.
My more measured response would be to emphasize a) some basic, crude, but useful ‘facts’ b) the value of getting hard data.
A. We still don’t understand business cycles very well but we do think it very likely that credit availability (or its lack) play a significant part. Severe restrictions on credit associated with financial panic have figured prominently in past downturns. Thus, given the severity of the current credit situation, it is likely that the ‘real’ effects on employment and output will be significant.
B. Financial firms in a financial crisis can fail for two reasons:
- Illiquidity: i.e. insufficient funds to pay immediate liabilities. This is the classic bank run.
- Genuine insolvency: assets (even evaluated at a reasonable horizon) are insufficient to cover liabilities.
One of the major purposes of banks is to solve ‘liquidity’ mismatches: I want to lend on call but you want to borrow for 20 years. Because of this a bank even when ‘sound’ can if there is a sufficiently large withdrawal of funds in a short enough time period (and borrowed funds cannot be found). This is the classic bank run — though it can also apply to any financial institution which has a potential liquidity mismatch (i.e. creditors have money on call but money to debtors is tied up for a longer period). Clearly, public policy will usually differ across the two cases: whereas public support for a sound institution facing a run seems common sense, ‘propping up’ a bankrupt one seems less sensible.
One of the major difficulties, for a casual observer of the current crisis such as myself, is distinguishing exactly which institutions fall into which category. Was Lehmann Brothers bankrupt of just facing a bank-run, ditto for AIG and Fannie Mae? Moreover, the very fact that uncertainty exists may result in such a freezing of credit — due to fears over counter-party defaults — as to cause failures of Type I as well as Type II institutions (as well as substantial collateral damage to all borrowers — i.e. most businesses).
Also difficult is that fact that Type I can shade into Type II because the forced sale of assets to meet ‘margin calls’ (be these payments to bank depositors or any other creditor) tends to depress asset prices. In the worst-case we have the classic ‘fire-sale’ in which the urgent need for cash leads to forced sales at massively reduced prices. Since this depresses the price not just of the firm selling but for all other firms holding that asset this can initiate a continuing downward spiral of sales (though, of course, we need to explain why there aren’t enough ‘rational buyers’ on the other side to drive prices back to equilibrium — the simple answer being that such buyers are facing the same tightening of credit as everyone else).
In the present case things seem to have been made worse since many (some?) of the assets held by banks were in the form of illiquid and opaque CDOs and CMOs (collateralized debt/mortgage obligations). Since these are rarely traded, pricing them (marking them to market) is not always easy. In times of ‘panic’, mass-selling driven down their price massively, perhaps far below any likely future price level, but forcing all holders (including non-sellers) to mark down their value. Normally, the link between price today and price tomorrow should be enforced via arbitrage but as already noted that link can disappear in the crisis.
At the same time, it is also likely that such securities were overpriced (or under-risked) previously. In particular, many of the mortgage based securities appear to have been overpriced relative to their risk, due to over-optimistic predictions for the future price path of housing, and (in the US), extrapolations of historical geographic price correlations which turned out to be too low (house prices, since these closely relate to the long-term path interest rates and economic growth are especially sensitive to revisions in beliefs about these factors). Similarly, as the possibility of a global recession has turned into seeming certainty, there has been a substantial re-evaluation of expectations regarding business earnings, at least over the next few years which has fed through in stock markets.
Though it is likely, to judge from past experience, that markets have over-reacted, it is not easy to say by how much: at least some of the change is due to genuine changes in expectations about the future paths of real variables and not simply the self-fulfilling dynamic of a crash. Returning to our previous points, it is exactly this uncertainty that helps feed the crisis, and simultaneously the reason that hard data is so important. Exactly how much of what assets are given institutions holding? How far have they already been marked down? What were the implied earnings level of prices a year and a half ago compared with today? How far do house prices in the US have to fall before X goes insolvent? (If the answer is 20% we should be worried if it is 50% we probably should not).
Of course, financial institutions — and others — are loath to disclose this kind of information for precisely the the reason that it may reveal their precarious position. But perhaps the time has come when we need this information out in th open.
