A Simple Theory of the Financial Crisis
We are not as shielded from a sudden dose of bad luck as we would like to think.
The Financial Crisis: One Possible Scenario
Fundamentally, the current financial crisis is not about the bursting of a real estate bubble. Although housing and subprime loans were the proverbial canary in the coal mine, the real problem was that investors chose too many risky assets of many different kinds. Nor is the financial crisis about mistakes in the banking sector, although many such mistakes were made. At bottom, the financial crisis has been a story of how poorly suited we are at handling unexpected systemic risks, especially those that stem from the so-called real economy. In essence, the story of the current financial crisis can be told in three broad chapters: (1) the growth of wealth, (2) the decision to opt for risky investments, and (3) the underestimation of a new source of systemic risk.
First, starting in the 1990s, global wealth grew enormously. Communism fell, world trade expanded, China grew at about 10 percent a year, and the investing class experienced unprecedented gains in income and wealth. Strong demand to invest the new wealth existed. Before Ben Bernanke became Fed chairman, he coined the phrase “global savings glut” to describe this new state of affairs.
More and more wealth was released into financial markets as many countries—including Spain, Iceland, Ireland, and the United Kingdom— modernized their financial systems. China channeled its new wealth into U.S. credit markets by buying T-bills and mortgage agency securities. These purchases freed up other funds for the pursuit of riskier investments.
The second basic trend was the increased willingness of both individuals and financial institutions to make risky investments, including the purchase of overvalued equities, risky derivatives positions, loans to such highly leveraged companies as AIG, and real estate loans (especially subprime loans). Many of these risks were not based in the financial sector but, rather, involved unduly optimistic revenue models, as we have seen in the automotive industry, state and local governments, and such “Web 2.0” companies as Facebook. Some of the risky investments included speculation in volatile commodity prices, which spread the boom–bust cycle to such commodity exporters as the oil-exporting countries.
The risks of many investments were aggravated by increases in leverage. Many U.S. investment banks moved from leverage ratios of about 12 to 1 to ratios of about 30 to 1 and expanded their investments in risky assets in the process. The result was a lower margin of error for profit-and-loss calculations, and thus, these high leverage ratios were not validated.
Many believe the Fed is largely responsible for the crisis. From 2001 to 2003, Alan Greenspan, the former Fed chairman, kept the federal funds rate at 1 percent, but monetary policy was not fundamentally at fault for the resulting overreach. If monetary policy had been the primary driver of the credit boom, investment would have gone up and consumption would have fallen. After all, without an increase in real resources (the global savings glut), an economy cannot expand on all fronts at the same time. But consumption was highly robust during the boom, especially in the United States. This fact implies that the resources behind the real estate and financial asset boom came from the real economy and that the Fed is largely not to blame for the current crisis. The presence of major financial problems in “tight money” Europe is consistent with this interpretation.
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This article has originally appeared on morningstar.com.
