Thursday, October 2, 2008

What Can We Learn From The Financial Crisis?

At the moment, the focus is on finding short term solutions to the pressing problems - How to bail out banks? How to prevent money markets freezing? How to prevent a minor recession turning into a deep recession?

But, in the long term, there are many lessons to learn from the current financial / credit crisis.

1. The Financial Sector cannot be trusted to regulate itself.

The mantra of the 80s and 90s was 'free markets' and deregulation'. Wall Street told us free markets were best at allocating resources, and the complex derivatives markets helped increase efficiency of markets. The same people who cried for financial deregulation are now the same people who want and expect the biggest ever government bailout and or subsidy. It is like a gambler who has run up huge losses and now, rather than go bankrupt expects the government to pay off his debts so he can go back to his gambling habit.
  • One example of lax regulation. - In the US, there was insufficient regulation of mortgages. This regulatory freedom allowed an unprecedented expansion of the mortgage industry; this involved aggressive selling of subprime mortgages to people who couldn't really afford it. This lack of regulatory oversight has caused unprecedented problems. Firstly, it fuelled a boom and bust in house prices. Secondly, it caused a series of loan defaults the global banking system is still struggling to deal with.
  • Another example - allowing short selling on falling stocks. see: short selling explained
2. Moral Hazard

A major objection to the current government bailout is that it encourages future reckless behaviour. If a manufacturing firm goes bankrupt, it won't expect to get bailed out. Therefore, it will try hard to follow sensible management. The argument is that because banks have a privileged position, they feel they can rely on getting bailed out.

For example, after the dotcom boom and bust, the government cut interest rates aggressively to prevent a recession. However, by keeping interest rates too low for too long, they encouraged another boom and bust, this time in the housing market. The argument is that sometimes it is better to let things fail to deal with the fundamental disequilibrium. If you keep papering over the cracks, the underlying problem gets worse. This point is quite complicated, there are many caveats and issues to consider. But, one thing is clear, government intervention needs to be very careful so it does not create incentives to create more problems in future.

3. Traditional Business models will Come Back into fashion

In the UK, banks like the Halifax and Bradford & Bingley used to have a very sound, profitable business models. They collected savings from customers, and then lent out mortgages. They were careful who they lent to, and were scrupulous in checking income. This business model is still profitable, UK banks operating profits have been very high in recent years (in fact some argue they are too high and indicate monopoly power). The problem is that the banks entered new markets, which were a departure from the traditional business model. They lent more risky mortgages. But, also got involved in raising finance on the money markets and used derivatives to extend their balance sheet.

To make things simple, they started to borrow in order to lend more. They were lending money, which wasn't theirs. They would hedge these loans with other insurers. This meant their business became intricatly linked with the wider money markets. When the money markets were doing well, it looked a way to make more money. But, when the money markets seized up, it left them very exposed and their balance sheets looking very vulnerable.

What it means is that the mortgage sector will become more circumspect and banks will concentrate on core business models, rather than trading derivatives, and seeking spectacular short term profits in non productive activities.

4. Savings Ratios Need to Increase

The savings ratio has been very low in both the UK and US. In September 2008, the UK savings ratio dipped below 0% for the first time since 1958. This reflects the low savings and high volume of debt in the economy. The US has also seen record low savings ratios. The 2000s have seen a culture of debt become widespread. Personal debt has risen to an all time high.

5. Culture of Debt is Dangerous

A culture of debt is problematic because.
- It makes consumers, firms vulnerable to interest rate changes.
- Contributes to current account deficit
- Leaves unbalanced economy

See: Problems of Personal Debt

6. Boom and Bust in Asset Markets

Governments in UK and US did a good job in preventing boom and busts in the economic cycle. We haven't had high inflation and booms like in the Lawson Boom. However, whilst they were busy congratulating themselves on avoiding boom and busts in the economy, they ignored the problem of boom and busts in asset markets like the housing market (see: Boom and Bust in US Housing Market)

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