Good Customer Service versus Bad Regulation
Learning from Gandhi:
addressing the current
dilemmas in microfinance
Hinduism and Microfinance
The Financial Crisis
A Sketch of a Credible Explanation
Money Market Funds, Bank Runs and the First-Mover Advantage
The Morality of Money Lending
The Case for Central Bank Liquidity Facilities for Institutional Money Market Funds in the Offshore Market
Creating Sustainable Micro-lending in London
Darwin and Philosophy
David Hume's "Of Suicide"
Is God a democrat?
The Risk Premium
The financial crisis of 2007-09 was surprising in two respects. The first surprise was that the crisis caught most of us by surprise; that is, most of us had forgotten the propensity of our financial system to periodic bouts of panic, accompanied by bank collapses and recession. The second surprise was that, having been caught unaware by the crisis, most of us have shown little interest in understanding its underlying causes. Just as we showed a lack of foresight beforehand so too we have shown a lack of curiosity since.
This paper sets out a sketch of a credible causal explanation for the financial crisis. I do not provide a detailed narrative of the crisis itself, nor a thorough examination of all the causal factors and their relative importance. My more modest ambition is to identify what it is that requires explanation and what would need to be included in such an explanation for it to be credible. There are already a large number of accounts of the financial crisis, which differ both in emphasis and in tone (Lo, 2012). Although I refer to some of these accounts I do not discuss them in any detail. Nor do I provide an extensive bibliography, although these are available in some of the works I cite. For example Gary Gorton's recent book (Gorton, 2012) contains twenty-five pages of bibliographic notes and twenty-five pages of references.
Financial crises are neither new nor uncommon. In the past one hundred and twenty years there have been eight major financial crises (Cassis, 2011) and economic historians have data on financial crises going back eight hundred years (Reinhart & Rogoff, 2009). While the timing of financial crises might be hard to predict their recurrence should not be unexpected. For any particular case, the interesting question is: Why did this financial crisis happen at this time and in this way? A credible explanation for each financial crisis will need to describe the various factors that made the financial system vulnerable to crisis, and the proximate cause, or trigger event, that precipitated the crisis at a specific time.
In some cases the explanation might take a standard format, because the crisis itself was standard in its causes and consequences. For example, in the 1890s British banks, in particular Barings, lent too much money to South American countries, in particular Argentina, and when it became clear that the Argentines could not pay back their loans a banking crisis ensued. In the 1980s American and British banks, in particular Citibank, lent too much money to Latin American countries, in particular Mexico, and when it became clear that the Mexicans could not pay back their loans a banking crisis ensued.
Not all financial crises are so easy to explain. The most important financial crisis of the twentieth century remains something of a mystery. As the economic historian Harold James writes,
The 1929 crisis is a substantial curiosity in that it was a major event, with truly world-historical consequences (the Great Depression, even perhaps the Second World War) but no obvious causes. (James, 2009, p.47-8)
James goes on to observe that not only do we lack a convincing explanation for the underlying cause of the stock market crash in New York in October 1929, we also lack a trigger event: that is, we know neither why the crisis happened nor why it happened when it did.
Trigger events are interesting for two reasons. First, they allow us to date the start of the crisis; they signal the start of something that is unusual but significant. Second, they reveal the vulnerability of the financial system to small, disruptive events.
The event that heralds the onset of a crisis is often, of itself, insufficient to explain the depth of the crisis that unfolds: the scale of the cause appears dwarfed by the scale of the effect. Identifying the trigger event, or proximate cause, helps to give structure to the explanatory account, but is insufficient of itself to make the explanatory account credible.
To take an example from military history, scholars continue to argue about the causes of the Great War (1914-1918) not least because the scale of the destruction that was unleashed across much of Europe, and beyond, demands a deep and complex explanation. All agree that the trigger event was the assassination of Archduke Franz Ferdinand by Gavrilo Princip, in Sarajavo on 28 June 1914 (Strachan, 2003). Nobody thinks that an account of Princip's actions would, of itself, be sufficient to explain four years of death and devastation, with around eight millions fatalities and a further fifteen million injuries. A credible explanation for the Great War also requires an account of how the economic, political and military rivalries between the nations of Europe made the continent ripe for war.
It seems plausible to argue that the trigger event for the financial crisis of 2007-09 occurred on Thursday 9th August 2007, when BNP Paribas suspended three of its investment funds due to its inability to secure accurate valuations for some of the assets held in these funds. Of itself, this incident was of little interest except for those investors directly affected by the fund closures. Nevertheless, within days, key parts of the global financial system began to experience exceptional stresses and difficulties, which lasted for eighteen months (Brunnermeier, 2009). During this time a sizeable number of the world's largest financial companies either collapsed or were taken over, or were rescued with public funds.
What would a credible explanation for the financial crisis of 2007-09 look like? It would provide an account of the various factors that, in combination, made the global financial system vulnerable to breakdown such that a relatively minor event - the BNP Paribas fund closures - was sufficient to initiate the series of price falls, market failures and institutional collapses that constitute the crisis. It would explain why the financial system lacked the resilience that it demonstrates in normal times. In my sketch this explanation starts with the US housing market, then moves on to consider in turn: asset securitisation, collateral management in the financial sector, the Basel II banking regulations, US monetary policy, Chinese currency policy and the economic policies of both Asian and Western nations. Thus, I suggest, that a credible explanation for the financial crisis implicates not just those who worked in the financial services industry, but regulators, policy makers and voters too.
In May 2006 the Case-Shiller House Price Index fell for the first time since June 1995. After more than a decade of month-on-month price rises leading to a tripling of valuations over that period, house prices in the US fell by 1.5% in the second half of 2006 and by a further 2.5% in the first half of 2007.1 For those who believed that US house prices could only rise in value this was, no doubt, an unpleasant surprise; but it hardly amounted to an exogenous shock to the financial system. By contrast, in the two years from July 2007 to July 2009, house prices fell by 28%, which would certainly count as a shock, as real estate prices lost around half of the gains of the previous decade. Thus, by July 2009 US house prices were on average only double what they had been in June 1995.
The end of the real estate boom in the US preceded the financial crisis by around one year. The deterioration of the level of house price valuations gradually percolated into the valuations of financial assets. As financial assets became tainted by their associated with the property market and started to fall in value, so they became hard to price and harder to sell. Markets did not just drop in value, they also suffered from a decline in liquidity: there were many sellers and few if any buyers, so price-matching failed to occur.
Real estate booms sometimes end without causing banking crises; and sometimes the banking sector goes into crisis without being preceded by the end of a real estate boom. However the two phenomena have been regularly correlated in many different countries (Herring & Wachter, 1999). As house prices rise, so loans collateralised with property assets increase in value and the perceived risk of lending to the property sector declines. Banks tend to become complacent about the risks of a fall in property values, but when these eventually occur they prompt a fall in value of collateralised loans and a rise in the perceived risk of the property sector. Banks start to withdraw funding, leading to a loss of confidence and further falls in property values. Real estate cycles tend to be more extreme than cycles in some other asset classes, both because the amount of available land for purchase is fixed (at least for the short-term) and because it is difficult to take short positions in the market for land.
The process whereby a fall in prices in one sector, or asset class, leads to falls in prices in other sectors, or other asset classes, is known as contagion. In some cases contagion is one-directional and limited in effect: a fall in the price of A leads to a fall in the price of B. In other cases contagion can be two- or multi-directional and lead to the amplification of effects: a fall in the price of A leads to a fall in the prices of B, C and D, which in turn lead to further falls in the price of A, which in turn leads to further falls in the prices of B, C and D, and so on. The amplification of contagion is especially likely when durable assets, such as land and property, have been pledged as collateral for loans (Kiyotaki & Moore, 1997). The importance of the productive function of these assets in the economy is temporarily augmented by their importance as financial collateral. In 2007, no matter where real estate was physically located in the US, its importance was felt most strongly on Wall Street.
During the summer of 2007, growing aversion to MBS as an asset class reflected a new awareness among market participants that the recent falls in US house prices would lead to a credit deterioration in some MBS deals. It followed that other securities, including many collateralised debt obligations (CDOs), which had been constructed by bundling together a selection of tranches from a diverse range of securitised debt instruments, would also likely suffer a fall in value. Quite what price should be assigned to any given tranche of any given security would depend on a clear understanding of the precise composition and credit ranking of the many constituent elements of that tranche. To determine a realistic price for each security now required a considerable analytical effort and rather more effort than most market participants were willing to make. Further, the credit rating agencies, whose judgements on these matters had previously been taken as mostly reliable, were now no longer trusted.
Once it became clear that the whole class of MBS assets were - temporarily - unable to be priced, they became undesirable to own as assets in an investment fund and unattractive to accept as collateral for repurchase transactions ("repo trades"). Within the wholesale banking market, assets that are straightforwardly trustworthy and whose price determinants are transparent to reasonably well-informed market participants are essential for the provision of liquidity. MBS, along with many other types of securitised debt instruments, had been widely used for this purpose but once they ceased be regarded as "information-insensitive" collateral, then a peculiarly modern bank run ensued (Gorton, 2010).
To understand better these connections between falls in real estate prices and falls in the liquidity of key financial asset markets we need to consider, in turn, the characteristics of the structures that were used to create sub-prime MBS in the years leading to the financial crisis and the attractiveness of assets of this kind for banks and asset managers in the normal conduct of their business.
The source of the valuation problem for MBS as an asset class can be traced to particular features of the sub-set of MBS securities known as sub-prime. This sub-set suffered from two sorts of weakness: first, some sub-prime MBS were structured in such a way that the borrower relied upon capital gains from the property during the first two or three years of the mortgage to allow the mortgage to be re-financed once the introductory or "taster" rate expired. If house prices did not rise, the borrower would be unlikely to be able to afford the stepped-up mortgage rate and would probably default on the loan. These MBS deals were not simply bundles of housing loans that were sold-off to investors; they were an implicit form of leverage that allowed borrower, lender and investor to increase the size of their exposure to the housing market on the assumption that house prices would continue to rise.
Second, some mortgage originators made no effort to check the accuracy of the information on the loan documentation, in particular the income of the borrower and the value of the property when purchased. Mortgage fraud was known to be taking place, although the scale of the problem was less clear. The combination of rumours of fraud, plus the knowledge that the economics of many sub-prime deals relied on the assumption of rising house prices, led market participants to become wary of the difficulty of valuing all MBS. While not all deals were equally risky, the time and effort required to distinguish the most risky from the least risky was sufficiently high that most market participants quickly became averse to this asset class as a whole.
Sub-prime MBS is the mechanism that transmitted and then amplified the impact of small falls in US house prices in late 2006 and early 2007 to the financial markets. This led to the closure of BNP Paribas's investment funds, in August 2007, and then to rapidly developing problems within the interbank lending market over the following weeks, which led in turn to the collapse of Northern Rock in the UK in September 2007 (Shin, 2009), followed over the next 18 months, by the collapse of Bear Stearns, Lehman Brothers, RBS and many other financial institutions.
There were good reasons why mortgage lenders were willing and able to provide loans for houses to a growing number of US citizens, including many from groups that had, historically, been excluded from the opportunity of becoming home-owners. Such loans could be packaged up into MBS (and re-packaged into CDO) and sold to banks and asset managers. Banks held them on their balance sheets as loans and asset managers held them in portfolios for their clients. In both cases, the attractiveness of these assets was determined by their cheapness relative to other asset classes with comparable market size, credit profile and ease of trading. MBS were precisely the sorts of assets that well-informed and rational investors would prefer, given the rules or guidelines under which they were operating.
For banks, the level of capital reserves they hold against their loans is determined by national regulators according to international standards, known as the Basel Rules. These rules define the level of capital required according to the perceived riskiness of the loans that the bank has made. The regulators gave discounts on the capital required for certain loans, if they regarded them as posing a lower risk to the banks' capital position. For example, under Basel II, loans to AAA-rated sovereigns required no capital at all to be held against them, whereas loans to BBB-rated sovereigns required 50% of the standard capital calculation. Since loans backed by durable assets were regarded as less risky than unsecured loans, all asset-backed securities, including MBS, with an A-rating or better received a discount on the standard capital calculation: A-rated MBS were given a 50% risk-weight and AAA-rated MBS were given a 20% risk-weight. This meant that, for the same quantum of capital, a bank could hold twice as many MBS bonds with an A-rating, or five times as many MBS bonds with a AAA-rating, compared with non-MBS bonds with a standard 100% risk-weighting.
The regulators did not create this incentive for banks to hold securitised debt by accident; they did so deliberately. According to the Basel Committee for Banking Supervision, "loans fully secured by mortgage on occupied residential property have a very low record of loss in most countries" (quoted in Friedman & Krauss, 2011, p. 63). Regulators wanted to give banks an incentive to avoid excessive risk taking, so they encouraged them to buy securitised debt because they firmly believed that the risk of default on such assets was lower than the risk of loss attached to unsecured loans and equity holdings. Banks were encouraged by the regulators to hold MBS as a risk-reduction strategy. Since bank capital regulations were developed and harmonised internationally, such encouragement occurred in all the major developed economies. All banks had good reason to buy AAA-rated MBS, driven not by a desire to increase their risk profile, nor to maximise their profits, but by the need to comply with a regulatory framework that privileged tradable securities, with high credit ratings, backed by residential mortgages.
For fund management firms the incentives were different but equally pressing. Many of their largest clients - including pension funds, insurance companies and sovereign wealth funds - wanted access to high quality assets with good liquidity. In some cases these assets were simply a safe, short-term investment for holdings of cash where the preservation of capital was of greater importance than high returns. In other cases, these assets were needed as collateral for synthetic investment products based on derivative transactions. Investors seeking to hedge exposure to long-term liabilities or inflation risk, or seeking to hedge exposure to commodity prices or foreign exchange risk, would buy a product that made use of futures, swaps or options, designed to hedge the precise risk profile required. These derivative transactions required liquid assets to post as margin and to hold as security to prevent unintended leverage occurring in the transaction. Given the high cost of liquid bonds of high-credit quality, such as US Treasuries, asset managers started to make use of MBS as a low risk asset that provided a depositary for their clients' cash holdings and backing for their clients' derivative trading positions.
Thus far I have identified the trigger event for the financial crisis and the mechanism by which property valuations in the US housing market were connected to the financial sector, amplifying the impact of modest falls in the value of house prices during 2006-07 such that the market for MBS securities became illiquid over the summer of 2007. There are good reasons that explain the growth in the supply of sub-prime MBS: many Americans wanted to own their own home and were willing to take on the risk of a sub-prime mortgage because they anticipated continuing increases in house prices. There are also good reasons that explain the growth in demand for sub-prime MBS assets in the financial system: banks and asset managers needed pools of highly-rated, liquid assets for investment and collateral management purposes. Further, the Basel Rules made MBS particularly attractive for banks to own because of the steep discount in regulatory capital that was on offer. If the growth in supply and demand for sub-prime MBS are accounted for, what else needs to be explained?
In the financial markets there is presumed to be a clear relationship between the level of risk attached to any given investment and the level of return that might be expected from this investment. In simple terms, the higher the expected risk the higher the expected return. This relationship does not hold true for all assets in all holding periods, however there is a reasonable expectation that if the prices of assets move out of line with their risk profile, then investors will have an incentive to take advantage of this discrepancy and, by a process of arbitrage, prices of assets will fall back into line with their risk profile. If risky assets are relatively cheap, investors will buy more of them thereby pushing their price back up; if low risk assets are relatively expensive, investors will sell them and their prices will drop back down to a more appropriate level.
Our search for a credible explanation for the cause of the financial crisis can therefore be restated through the following set of questions: Why did the prices of sub-prime MBS not reflect the real risks associated with this type of asset? Why did investors not sell (or short) the market in greater volume, thereby forcing the prices of these asset back down to a level that better reflected their inherent risks? Why did regulators and policy makers not act earlier to deal with the bubble in US property prices and the associated bubble in sub-prime MBS prices? The answers to these questions make reference to the various factors that help to determine the prices of financial assets, including the level of interest and exchange rates, and the changing patterns in the supply and demand of financial assets for the investment of savings.
The role played by MBS on bank balance sheets and in asset portfolios in the years leading up to the financial crisis had previously been played by government bonds, notably US Treasuries. Bonds issued by highly-rated sovereign issuers were regarded as low risk and were often highly liquid, making them ideal as an investment product for conservative cash savings and as collateral for repo trades and margin for derivative transactions. When the prices of US Treasuries became very high, the returns they offered became unattractive, so banks and asset managers started to look for an alternative asset class that would be less expensive, hence the attractions of MBS. Why were US Treasuries so expensive? In part because interest rates were unusually low and in part because demand was unusually high. I will address each of these points in turn.
In the second half of 2000, short-term interest rates in the US (known as Fed Funds) were around 6.5%. During 2001 rates started to fall as the Federal Open Markets Committee (FOMC) responded to fears of an economic slowdown consequent upon the collapse of share prices of new IT companies, the so-called "dot-com crash". Then, after the terrorist attacks on New York and Washington in September 2001, the FOMC lowered rates more rapidly so that by the start of 2002 they were as low as 1.75%. (Fed Funds had not been this low since the mid-1950s). Short-term interest rates eventually fell as low as 1%, before starting to rise in the second half of 2004. By this time, the FOMC were worried that rapid economic growth and asset price inflation might lead to higher consumer price inflation. From their low of 1% in the summer of 2004 Fed Funds rose to 5.25% by the second half of 2006. (It was at this point, when higher interest rates fed through to the cost of mortgage refinancing, that the property bubble came to an end).
When short-term interest rates are very low for an extended period so also longer-dated interest rates tend to fall, which means that that the prices of longer-dated bonds rise. Investors are able to borrow short-term funds cheaply and invest them in longer-dated assets, to take advantage of the price spread. Increased buying of longer-dated bonds causes their prices to rise and the yield curve flattens. While this process provides investors with an opportunity for capital gains, it also makes the cost of holding US Treasuries as collateral very expensive. Banks and asset managers have an incentive to reduce their holdings of expensive US Treasuries and to buy other highly-rated assets, such as MBS, instead. This shift from sovereign debt to securitised debt was a perfectly rational response to the fact that US Treasuries were expensive (many would say, over-priced) owing to a long period of unusually low interest rates.
As banks and investment managers switched from US Treasuries into MBS, had other things all been equal, the price of US Treasuries should have fallen. In addition, when the FOMC signalled the start of a period of rising short-term borrowing costs, in the summer of 2004, yields at the longer end of the bond curve should also have started to rise, in anticipation of higher short-term funding costs. In the period from 2004 to 2006 this did not occur. Despite the fact that many traditional owners of US Treasuries were selling them to buy MBS and despite the fact that the FOMC has started to increase the Fed Funds rate, the longer end of the yield curve remained very expensively priced.
The best explanation for this phenomenon is that demand for US Treasuries from other, non-traditional buyers far outweighed the impact of sales by traditional holders. These new buyers were primarily Asian individuals and institutions, who were seeking a safe home for their surplus cash holdings (Warnock & Warnock, 2005). One characteristic of rapidly developing economics - of which China is the largest but not the only one - is that they are able to generate financial wealth in the form of savings far faster than they are able to create a stable set of institutions and instruments to manage this wealth (Caballero, Farhi & Gourinchas, 2006). Consequently, the surplus savings of the developing world, especially Asia, were used to buy up large volumes of US financial assets, in particular US Treasuries. The propensity of traditional holders of US Treasuries to require a higher yield in a rate-rising environment was overwhelmed by the scale of US Treasury purchases by Asian investors. Notwithstanding the fact that US government debt should, in normal market conditions, have been falling in value, the weight of new money coming into this asset class overrode other factors.
In the Bank of International Settlements (BIS) Annual Report of 2006, the authors identify the existence of a host of financial "imbalances" as one of the biggest risks to the stability of the global economy:
Perhaps the most important example of "fundamentals" failing to
adequately explain financial market developments is the long-term bond market in the United States (BIS, 2006, p.141).
In other words, regulators and policy makers were fully aware of the unusually low level of yields for longer-term US bonds and fully aware of the likely causes. Ben Bernanke, who succeeded Alan Greenspan as Chair of the Federal Reserve in 2006, has already set out an account of the relationship between Asian saving rates and low US interest rates (Bernanke, 2005). Further, this problem should not have come as any surprise to US or European policy makers, because it was merely a modern variant of an older problem, which had been discussed by academics and policy makers for almost fifty years.
Back in 1960 the Belgian economist Robert Triffin had argued that the post-war settlement, based on the US dollar as the principal currency for global trade and investment, would lead to a situation in which non-US investors would continue to acquire US dollar assets as their preferred store of financial value until such time as these investors realised that their claims were unredeemable. That is, either the US would not pay them back, or it would do so in a sharply devalued currency. At this point, so Triffin forecast, panic would ensue (James, 2009; Eichengreen, 2011).
This problem, which became known as the "Triffin dilemma", grew in significance for fifty years without ever being seriously addressed by policy makers in the US or elsewhere. Successive US governments spent more money than they raised in taxes year-on-year, and the US imported goods of greater value than it exported year-on-year. These twin deficits were funded by international investors, who judged US Treasuries to be the most secure form of financial investment. Many Asian nations ran current account surpluses, helped by artificially low exchange rates. The resulting cash was invested in the US placing downward pressure on US interest rates: by 2000 the US accounted for 75% of net global capital imports. This, in turn, kept borrowing costs low for US consumers, allowing them to spend more on imported Asian goods. US personal savings, which in 1970 were just over 10% of annual income, had fallen to 1.9% by 2000 and to 0.8% by 2005 (James, 2009). The world's wealthiest country was borrowing from poorer countries to fund its consumption spending: US consumers had no need to save because credit was plentiful and cheap.
The growth of sub-prime lending in the US and the growth of the market for sub-prime MBS assets were both responses to wider macro-economic factors: a period of abnormally low interest rates in the US, combined with an artificially low exchange rates in Asia, combined with the rapid growth of surplus savings in Asia that were invested in US Treasuries. (Although, for a dissenting view, see Borio & Disyatat, 2011.) Policy makers had been aware of these problems for many years and were fully aware that at the start of the twenty-first century these problems were growing in scale. For a number of reasons policy-makers made no serious attempt to deflate the bubble in US property prices, nor to reduce the exposure of the banking sector to MBS, nor to improve savings rates in the US, nor to reduce the current account surpluses of Asian nations. In part this was because many policy makers thought that these developments were benign: they spoke of "the great moderation" and "a decade of non-inflationary consistent expansion". In part, however, it was because addressing these large and growing imbalances would have required major changes not just to monetary policy and bank regulation, but also to economic and social policies; changes that were deemed political risky and to be avoided if at all possible.
For example, the Chinese government worried about the risk of growing social unrest associated with unemployment and low wages. Keeping the value of the Renminbi artificially low helped to keep production costs low, which in turn supported the growth of manufacturing employment opportunities. Surplus labour from the countryside could be absorbed in fast-growing cities where jobs were still plentiful, at least for a while (Shirk, 2007). In addition, one major consequence of the "one-child policy" that had been introduced by the Chinese government in the 1970s was that private sector savings rates in China had risen dramatically. When state funded welfare is insufficiently developed, and there is only one grandchild to support four grandparents so it becomes imperative that workers save a larger proportion of their income for their old age (Modigliani & Cao, 2004). Chinese economic and social policies required the exchange rate to be kept low, to encourage the export of cheap manufactured goods and surplus savings to the US.
Global re-balancing would have created the risk of major social disturbances if millions of workers lost their jobs and millions of old people lost the value of their savings.
Meanwhile the US government worried about living standards and consumer confidence, particularly among workers whose skills were uncompetitive in the global labour market. The US had given up its century long leadership in the quantity and quality of education provided for its workforce, leading to higher unemployment, low and stagnant wage growth, and a loss of economic competitiveness. One of the most successful mechanisms for concealing the problem of declining economic competitiveness was the promotion of cheap housing credit for all.
Growing income inequality in the United States stemming from unequal access to quality education led to political pressure for more housing credit. This pressure created a serious fault line that distorted lending in the financial sector. Broadening access to housing loans and home ownership was an easy, popular and quick way to address perceptions of inequality.
(Rajan, 2010, p.43)
Keeping domestic interest rates low while at the same time absorbing a huge inflow of global savings, allowed US consumers access to credit at a price which did not reflect the real risk of borrower default. For a time, the interests of Chinese workers and US consumers could be mutually satisfied, but the underlying problems of the global economy and the financial system were not addressed.
Over a long period financial imbalances grew, while those who pointed to the risks associated with these imbalances and their potential disastrous outcomes were ignored. Neither banks, nor regulators, nor policy makers seemed to understand that the status quo was unsustainable. What appeared to be in the short-term interests of everyone would turn out to be in the long-term interests of no-one. Taking action to reform the Chinese labour market and to develop a more robust welfare system, and taking action to improve educational standards and economic competitiveness in the US, were not impossible: but they would have been costly and unpopular. Likewise the central bankers and regulators could have taken action to raise interest rates in the US, or raise exchange rates in Asia, or to increase the level of regulation of the US mortgage market, or to reconsider the rules that provided substantial regulatory capital discounts for MBS paper on bank balance sheets: once again, each of these actions would have been economically disruptive and unpopular.
When property values started to fall in the US, in late 2006, and when banks found themselves unable to establish the fair value of MBS, in August 2007, the stage was set for a deep financial and economic crisis. Just as Gavrilo Princip provoked the Great War with two bullets, so BNP Paribas precipitated the financial crisis with three fund closures. That such small actions were able to achieve such great effects suggests that in both cases the trigger event needs to be considered within a much wider and deeper frame of causal explanation. I have attempted to provide a sketch of what a credible explanation for the financial crisis might look like. It is no more than a sketch but it does, I believe, address the important causal relationships: between US property prices and the liquidity of MBS; between regulatory incentives and wholesale market behaviour; between macro-economic policy and financial asset prices; and the political imperative to adopt social policies that (temporarily, at least) mitigated some of the consequences of global economic development.
Bank crises are a recurrent problem because asset prices tend to rise and fall in cyclical fashion, and when they fall suddenly and sharply then tend to undermine confidence in the banking sector. Knowing this we should not have been surprised by the financial crisis of 2007-09 and we should have been better prepared to respond to it. Unfortunately public policy delusions are also cyclical: we forget the lessons our forebears learned and we neglect to warn our successors about the problems we did not fully solve. We worry about the quantity of regulation rather than its quality: as if having more regulation was more important than having good regulation. We forget that while thoughtful, credible and tenacious politicians might be able to persuade us to sacrifice short-term gains for longer-term stability, most of the time most of us tends to prefer rising house prices, cheap consumer goods and lower interest rates. Policy makers understand this and craft their political manifestos accordingly. Without being cognisant at the time, those of us who are lucky enough to live in the Western democracies have, for the past twenty-five years or more, regularly voted for the financial crisis.
Thanks to Nora Colton and Jake Richards for comments on an earlier version of this paper.
1 The 10-City Composite Index, produced monthly. All data in this paragraph from S&P.
Bank for International Settlements (BIS). 2006. 76th Annual Report.
Bernanke, Ben. 2005. "The Global Saving Glut and the US Current Account Deficit", speech given on March 10th, 2005, Board of Governors of the Federal Reserve System.
Borio, Claudio & Piti Disyatat. 2011. "Global Imbalances and the Financial Crisis: Link or no link?", Working Paper 346, BIS Working Papers.
Brunnermeier, Markus. 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008", The Journal of Economic Perspectives, 23:1 (Winter, 2009), pp. 77-100
Caballero, Richard J., Emanuel Farhi & Pierre-Olivier Gourinchas. 2006. "An Equilibrium Model of 'Global Imbalances' and Low Interest Rates", Working Paper 11996, National Bureau of Economic Research.
Cassis, Youssef. 2011. Crises and Opportunities: The Shaping of Modern Finance, Oxford University Press.
Eichengreen, Barry. 2011. Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System, Oxford University Press.
Friedman, Jeffrey & Wladimir Kraus. 2011. Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation, University of Pennsylvania Press.
Gorton, Gary. 2010. Slapped by the Invisible Hand: The Crisis of 2007, Oxford University Press.
Gorton, Gary. 2012. Misunderstanding Financial Crises: Why we don't see them coming, Oxford University Press.
Herring, Richard J & Susan Wachter. 1999. "Real Estate Booms and Banking Busts: An International Perspective", Working Paper Series 99-27, Wharton Financial Institutions Centre.
James, Harold. 2009. The Creation and Destruction of Value: The Globalization Cycle, Harvard University Press.
Kiyotaki, Nobuhiro & John Moore. 1997. "Credit Cycles", Journal of Political Economy 105:2, pp.211-248.
Lo, Andrew. 2012. "Reading about the Financial Crisis: A 21-Book Review", dated 9 January 2012, found at: http://www.argentumlux.org/documents/JEL_6.pdf.
Modigliani, Franco & Shi Larry Cao. 2004. "The Chinese Saving Puzzle and the Life-Cycle Hypothesis", Journal of Economic Literature XLII, pp.145-170.
Rajan, Raghuram. 2010. Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton University Press.
Reinhart, Carmen & Kenneth Rogoff. 2009. This Time is Different: Eight Centuries of Financial Folly, Princeton University Press.
Shin, Hyun Song. 2009. "Reflections on Northern Rock: The Bank Run That Heralded the Global Financial Crisis", The Journal of Economic Perspectives 23:1, pp.101-120.
Shirk, Susan L. 2007. China: Fragile Superpower, Oxford University Press.
Strachan, Hew. 2003. The First World War, Viking/Penguin.
Warnock, Francis E. & Veronica Cacdac Warnock. 2005. "International Capital Flows and US Interest Rates", International Finance Discussion Paper 840, September 2005, Board of Governors of the Federal Reserve System.
Honorary Research Fellow
Institute of Philosophy, University of London