opinion the daily column thinking too loud

Crisis! The Mega Musical

You almost want to set a musical to images like those found at this brand-spanking-new tumbl-log.

I’ve largely tried to stay out of saying anything on this “credit crisis” because there are far more credible experts out there, such as Nobel Laureates who blog (a first?). However, it’s getting to the point where I just have to ask one thing – why is everyone in a position of authority seemingly caught unawares?

The Background – or why this matters

The “credit crunch” is taking place behind the scenes far more than it is on measures visible to the public – the equity markets are a mirror to the murky world of money markets, where once billions of dollars flew around the world daily. When I joined DB, I was told almost point blank – the stock market measures you see is a vanishingly small component of what the business of a bank is all about. Brokerage and trading earns tidy sums, but the main reason banks exist is (was?) to handle the flow of money from those who have it to those who need it – creditors to debtors, the flow of capital.

It’s almost the idea that capitalism is built on – someone has extra money than they need, someone else has an idea for which they have insufficient money. The money is lent on the presumption of repayment in future, along with an interest charge to account for the time value and the utility that the money has provided. The borrower will borrow on the expectation that by using it – to buy tools, raw material, whatever – they will earn money from customers, use that to repay debt, and thus complete the cycle.

So: debt is fundamental. But what about shares?

Shares are a way to raise capital without the cost of interest, but in return you give up ownership, and often is limited by the properties of shares. Shares have the advantage to the investor that there’s unlimited upside – when profits are high, it’s returned to the share holders to the maximum value. On the flipside, shares also have unlimited liability – when things go bad, it’s possible to wipe out all your value. Debt is easier: it’s got limited upside – you only get paid back what you lent – and it’s got limited downside – you only lose as much as you lent, and in the capitalist system, you’re also first in line when things go belly-up.

The Crunch

Banks lent. Then they lent some more. Then they thought: I can sell this off and then lend some more again! And lent some more. Eventually, they got so addicted to the profits that they lent to people who really couldn’t pay it off if things turned out less than optimistic.

Which they did, inevitably – and then the crunch began. As default rates climbed, banks started to lose money, writing off values. The loans which had been sold on caused those who bought them to lose money. The haphazardly built house of cards came crashing down, and gradually, over the course of a year from last August, lending – credit – tightened.

Creditors feared that borrowers wouldn’t be able to pay back, so they hung on to their money rather than lending out again, or worse, called in loans. As borrowers sold, the glut forced prices down, and the feedback loop began in earnest. Asset prices falling meant the security against which the debt has been lent was less likely to recoup the cost of the loan, so creditors panicked some more.

As crashes go, the death of the credit market is proportional to the stock market bottoming out at about 1% of the highs.

So now we’re stuck at the point where no-one wants to lend to each other for fear of not getting paid back. Profit margins that were at 0.09% are over 2% for anyone that does lend, but still no-one is lending, and that’s what has everyone spooked – the grease on the gears of capitalism has dried up.

Why didn’t anyone see it coming?

Japan is ahead of the game: they did all this at the start of the 90s.

The Japanese banks lent money with reckless abandon in the 80s, and when the bubble was pricked, it all came to a crashing halt. It led to 10 years of neglegible growth of 1% or less, and petrified Japanese banks with billions of yen of bad debts that they couldn’t write off. The Japanese government attempted make-work programs to kick-start the economy, but failed to do anything other than run up 195% of their GDP as public sector debt. That is to say, it’d take two years of the dollar value of everything Japan made or did to pay off public debt – to contrast, Australia’s at about 14%.

The Japanese bubble was backed on exactly the same thing that the American bubble was – overvalued houses. While we’re skipping ahead to the Japanese solution implemented after nearly a decade – buying into the banks – why didn’t anyone spot the pattern in the first place?

Debt works, but only for so long. As money chased investment opportunities, debt was racked up on the assumption that it would always be as cheap as it was in the early years of the Double-Os, and that payback was a simple matter of selling it to the next sucker. The whole boom was fuelled by debt, not savings, and one day that debt would come due. What’s more, with leverage, the debt was quickly detached from any parity with earnings growth.

The problem seems to be that whenever these things happen, a collective someone thinks, it’ll be different this time.

Alright, but what do we do?

There’s no way to force people to lend money, short of the government taking it off them through taxes and budgets and lending themselves.

Oh wait.

In any case, it seems to me that when something is critical to the infrastructure of a system – like banks to capitalism – you would hope that there’s some level of control and constancy exerted on them. It’s pretty clear free-marketism only works if you’re willing to accept the downsides and the cycles. For a more stable system, you have to smooth the top of the cycle in order to ensure the bottom is smoother too – but that doesn’t sit well with those who cheer free markets (as long as it’s going up) and boo intervenion (unless it’s when their asses are on the line).

I’m an advocate of government involvement and infrastructure investment – critical pieces to the wellbeing of nations should not end up in private hands. To borrow a slogan, you’ve got to keep the bastards honest.


  • I work for a bank directly affected by this, and my job may be (is?) linked to recovery.
  • I’m not a US tax payer, and no longer a UK or EU tax payer.
  • I’m no finance or economics expert, so take the above as a crude explanation at best.

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