Steve KelseyWhy is our economy so unstable? Why do crises overpower our best systems built by our best minds? Or, if you reject the notion of intelligent control in our economic systems, why does a highly evolved system evolve towards chaos rather than stability?
To begin to understand how these instabilities arise let us look at the most recent.
The principle cause of the 2007/8 Global Financial Crisis was deception.
It started with the US Prime market where high-risk low value assets were bundled and re-bundled to obscure their origin and then marketed as low-risk high value assets. That was as crazy as it now sounds post 2007, but there was an underlying principle behind this method that makes a claim for respectability.
If you look at the history of bad loans not all of them go bad at the same time, people’s circumstances and fates vary. By bundling a lot of high-risk assets together you can spread the risk of each individual default over a larger number as a means to dilute the risk. You would have to be very unlucky for the economic conditions at anyone time to change so badly that lots of people got hit at the same time.
This is nonsense of course, people on low incomes are always the first to be hit in any economic downturn no matter how slight. So, there must have been a mitigating factor in the minds of the banks that offset this risk, and there was. Property prices at the time had enjoyed decades long growth and this growth looked likely to continue into the future. If someone did default, you could take ownership of a rising asset. Plus of course, you were not the person taking the risk. You were selling the risk to other people, for a commission.
So at some point in time it might have been possible for a bank to convince itself that, as the loans were asset backed, and the risk of default was mitigated by bundling lots of riskier loans together, this new vehicle really was better quality than it might seem. If you squinted at it the right way.
But this does not explain why the new financial assets were marketed the way they were. They were not marketed as low or moderate risk. They were rated as triple A assets, the best there is. It takes industrial levels of self-deception to convince yourself that selling mortgages owned by people with no jobs, no incomes and no assets was the same as selling assets backed by major corporations and governments. But it did make these dodgy assets easier to sell, and it did enable you to sell them at a higher price.
We all now what happened next. The US mortgage market collapsed, starting a chain reaction that spread around the world and out of the financial markets into the high street and then into everyone’s home. But how could this happen. In previous crisis the banks have coped with the fallout. Why were the banks were so fragile?
The reason is simple, all of the banks were all over leveraged.
All banks loan more money than they have in their reserves. It’s called fractional reserve banking. The banks hold enough money in reserve to cover the normal demands for cash from people and businesses day to day needs. They then loan a multiple of their reserves, creating the money in the form of loans. Banks make their money on loans by charging interest. The more loans they make, the more money they make. Banks compete aggressively with one another for business. The more aggressive banks are in making loans the larger they grow and the more money they make. Inevitably, over time, the amount of money the banks loaned relative to their reserves grew. Not to expand your loan ratio would mean you would be out competed by your competitors and that would make you vulnerable to a takeover. In the unrestricted and hyper competitive market of the 2000’s aggressiveness was the order of the day. By 2007 the banks loan to reserve ratio had grown to dangerous levels.
In 1971 banks in the UK had agreed to a 10:1 ratio for loans. That is, for every £1 they had on reserve they would lend out £10. /www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/1971/reserve-ratios-further-definitions.pdf
By 2007 this ration had grown to 40:1, for every £1 in reserve a bank was lending £40.
Loans had raced ahead of reserves because the banks with the greater appetite for risk were growing faster than the banks who were being more prudent. A risk war had set into the banking industry as each tried to out compete the other.
This system worked until it was put under stress by the financial crisis. The crisis began when interest rates rose in the US and homeowners began to fail to service their mortgage interest payments in large numbers. Income from these mortgages was failing, companies heavily invested in US mortgages were failing. It became obvious that the purportedly AAA investments were trash. Everybody wanted to get their money out, at the same time.
The first thing the banks did was to try to borrow money from other banks to increase their reserves. In normal times this might work, as it is rare for a bank to get into difficulty and so it can borrow from its peers to cover the emergency, or if that doesn’t work, the central bank as lender of last resort can step in.
But banks refused to loan to other banks because, knowing how dangerous state they were in themselves; they dare not loan to another bank because they might be in as bad a shape as they were. And they were right, every major bank was trading well beyond their ability to cope with a crisis. Every major bank could go bust.
That’s why governments around the world had to act, issuing new money by converting government bonds owned by the banks into cash assets, the process known as Quantitative Easing. A conservative estimate for the global cost of QE in 2007/8 is $5TN but is probably higher.
Hubris and self-deception, allied with deliberate deception of customers, are significant drivers of instability in the economy, and this is hardly a surprise to anyone.