Confidence, Tricked

What really precipitated the global financial crisis?

Since 2007, as banks took successive writedowns related to deteriorating mortgage-backed securities, the conventional wisdom was that we were facing a crisis of bank solvency triggered by falling housing prices and magnified by leverage. However, falling housing prices and high leverage alone would not necessarily have created the situation we face.

The problems in the U.S. housing market were not themselves big enough to generate the current financial crisis. America’s housing stock, at its peak, was estimated to be worth $23 trillion. A 25% decline in housing value would generate a paper loss of $5.75 trillion. With an estimated 1%-3% of housing wealth gains going into consumption, this could generate about a $60-$180 billion reduction in total consumption — a modest amount compared to U.S. gross domestic product of $15 trillion. We should have seen a serious impact on consumption, but there was no a priori reason to believe we were embarking on a crisis of the current scale.

Leverage did increase the riskiness of the system, but it did not by itself turn a housing downturn into a global financial crisis. How leveraged a bank can be depends on many factors — most notably, the nature and duration of its assets and liabilities. In the economy at large, credit relative to incomes has been growing over the last 50 years, and even assuming that credit was overextended, this financial crisis was not a foregone conclusion.

There are two possible paths to resolving an excess of credit. The first is an orderly reduction in credit through decisions by institutions and individuals to reduce borrowing, cut lending and raise underlying capital. This can occur over many years, without much harm to the economy. The second path is more dangerous. If creditors make abrupt decisions to withdraw funds, borrowers will be forced to scramble to raise funds, leading to major, abrupt changes in liquidity and asset prices. These credit panics can be self-fulfilling; fears that assets will fall in value can lead directly to declines in their value.

A Similar Crisis in the 1990s

We have seen a similar crisis at least once in recent times: the crisis that hit emerging markets in 1997 and 1998. For countries then, substitute banks (or markets) today. Both then and now, a crisis of confidence among short-term creditors caused them to pull out their money, leaving institutions with illiquid long-term assets in the lurch.

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3 Comments On: Confidence, Tricked

  • lthemanz | January 20, 2009

    Referring to the mentioned economic crisis of the ASEAN emerging markets in 1997-1998, how well are they placed now? Looking at Malaysia as an example based on the above mentioned 4 criteria
    1. Over-leveraged, from the CIA WorldFactBook :
    Stock of domestic credit:
    220 billion (31 December 2007)
    Reserves of foreign exchange and gold:
    $101.1 billion (31 December 2007 est.)
    Debt – external:
    $53.09 billion (31 December 2007)

    2. Commodity dependent – Malaysia does rely on oil and gas exports rather heavily. Singapore doesn’t.

    3. Poor countries – Maybe Indonesia to a certain extent.

    4. China / Manufacturing – A number of ASEAN countries depend heavily on electronic manufacturing exports, namely Singapore and Malaysia.

    Now taking the regulations employed by the Central Bank of Malaysia, ensuring banks are locally incorporated, to some extent making it on independent of the parent company e.g Citibank.

    It will be an interesting scenario to see how this countries have learned from the 1997 crisis and how they fare.

  • dwiesen | March 19, 2009

    I believe that technology holds the cure for sociological problems. How serious our present condition is depends upon the growth of technology over the next few years. If the technological change promotes a GDP growth exponentially larger than the deficit and debt growth then there will be no excess inflation
    and the economy will be in good shape.

    David L. Wiesen, ’54

  • milan | March 19, 2009

    human evil nature of excessive greed may be the underlying cause for the whole financial chaos. prudent allocation and diligent investment with astute risk management is the key for financial prosperity and a backup for sudden disasters.

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