Policy-makers are trying to cut through the Gordian Knot that is this banking crisis with rusty nailclippers rather than wielding a very sharp sword. The financial collapse that has engulfed the world economy can seem overwhelmingly complex, but in essence it boils down to two interacting financial theories that were tested to destruction. The first was that securitization, the slicing and dicing of individual asset risk at any given bank to be parcelled up and sold on, would lead to a more stable financial system by limiting the balance sheet concentration and hence vulnerability to external shocks of each institution. Risk was to be scattered to the four winds.
That neat idea ignored the systemic risks that ensued if most institutions lent recklessly on the assumption that their individual credit downside had been 'outsourced' to a seemingly bottomless pool of anonymous global investors. In other words, an innovation meant to reduce specific risk ended up raising systemic risk. This was exacerbated by the emergence in the latter stages of the boom of a new generation of ludicrously complex and ultimately unsaleable derivatives such as a 'Collateralised Debt Obligation of Asset Backed Securities' or CDO of ABS. Most of the $450bn issuance of this grotesque financial mutant was simply shoved off-balance sheet (and offshore) into Enron style vehicles such as SIVs in 2006/7.
The second dangerous idea was that emerging markets could grow their economies far faster than their financial infrastructure and simply export excess savings to the more sophisticated developed world banking system. In the process, by raising credit availability and lowering interest rates in the US and elsewhere, they effectively subsidized demand for their exports, leading to ever larger surpluses to be sent back to consumer nations in a perpetual motion machine of capital flows moving at an ever more frenzied pace. Some of that recycled capital found its way back to emerging markets via Western bank loans to local corporates and oligarchs. Once US consumer balance sheets began deteriorating sharply from late 2006 as the real estate bubble burst, both theories began unravelling fast. Unfortunately, economics isn't an exact science subject to laboratory experiment.
Now, we face the mammoth task of delevering the US and other economies in as orderly a manner as possible, dealing with the huge destruction of bank capital, and restoring confidence and trust between actors in the financial system. The credit intermediation system is in tatters; private securitisation was at the peak intermediating 50% of US household credit, and it has effectively imploded leaving central banks to plug the credit gap. As can be seen in the chart below, US household net borrowing has collapsed and business borrowing looks set to follow. While the focus has been on ensuring the supply of credit, a bigger question going forward may be the demand for it. No substantial economic recovery can take hold without the restoration of a sustainable private sector credit system. So what needs to be done to achieve it?
