An article in today’s Guardian by John Lanchester provides a useful summary of the current credit crisis, which I will quote as an introduction to some more fundamental issues raised later in the article:
Financial institutions in the US lent money to people with poor credit histories. This wasn’t a bad thing in itself … The invention that made it possible for the lending to become reckless was securitisation: the process by which loans were added together and sold on to other institutions as packages of debt. This had the effect of making the initial lender indifferent to whether or not the loan could be repaid. These packages of debt were then resold in the form of horrendously complex financial instruments, and it is these that are the basis of the global jamming-up of capital markets. The overlapping loans are so complicated that no one knows who owns what underlying debt, and, furthermore, no one knows what these assets are worth. The mechanism for assessing the value of these assets is the market: they are worth what someone is prepared to pay. At the moment, because no one is buying, no one has a clue what they’re worth, if anything. Because of an accountancy practice called “mark to market”, requiring that assets be listed at their current values, this fact had to be reflected in the companies’ balance sheets – so these balance sheets suddenly looked disastrous. As a result, banks are reluctant to lend to each other, and the entire financial system has ground to a halt: such capital as is moving in the markets is supplied by the central banks, which have to date pumped in hundreds of billions of dollars to generate some liquidity.
After going into some of the details about what individual banks and countries did, the article ends with a summary of the bigger picture:
So: a huge unregulated boom in which almost all the upside went directly into private hands, followed by a gigantic bust in which the losses were socialised. That is nobody’s idea of how the financial system is supposed to work. It is just as much an abomination to the free marketeer as it is to the social democrat or outright leftist. But the alternatives don’t seem to be forthcoming: there is a theoretical vacuum where the challenge from the left used to be. Capitalism no longer has a global antagonist, when it has never needed one more – if only to clarify thinking and values, and to provide the chorus of Schadenfreude that at this moment is deeply appropriate.
Having fully indulged their greed on the way up, and created the risks, the bankers are now fully indulging their fear on the way down, and allowing the system to seize up. But it wasn’t just the banks. One thing that has been lacking in public discourse about the crisis is someone to point out that we did this to ourselves, because we were greedy and stupid. We grew obsessed with the price of our houses, felt richer than we should, borrowed money we didn’t have, and now that the downturn has happened – as it was bound to do – we want someone else to blame.
Other than that, it’s too early to draw general conclusions from this amazing crisis. What must die is the mystical belief in the power of the markets that has dominated political and economic discourse in most of the western world for the past several decades. The markets have, so flagrantly malfunctioned that we can’t go back to the idea of unfettered liberal capitalism as a talisman, template or magic wand. Unquestioned Cityphilia is gone, I hope for ever. Unfortunately, we have no model of where to go from here, apart from a more heavily regulated form of growth-based liberal capitalism.
Now, on one level, this quote is somewhat disturbing, borderline terrifying. But, as a scientist, I can’t help but note the similarity to a scientific revolution. There is a crisis in the old model – its shortcomings have been made apparent by its failure to account for a novel situation. The search for new models is underway – will it just be a patch on the old model, or a complete overhaul? It will be interesting to see if the field of theoretical economics has a very productive decade in the aftermath of the credit crunch as bright young minds are drawn to the exposed problems of capitalism.
Still, it must be extremely difficult to model a phenomenon whose most basic element is “greedy and stupid” humankind. It makes astrophysics look comparitively straightforward.