Anatomy of a Financial Crisis

A former U.S. regulator was quoted in a recent article in the Financial Times saying, “if you had said a year ago that America could suffer a banking crisis on the scale of Japan, people would have laughed.” Of course, that “laughable” kind of (honest) rhetoric during the peak of the prosperity bubble was unwelcome and shunned. Just a bit over a year ago, one of the most incompetent CEOs to ever have managed a corporation was still claiming that better times were still on the horizon. Yet, at that time no one wanted to hear that such prosperity was an illusion, a castle made of sand. Wall Street had come to believe that human fallibility, along with the notion of risk, no longer existed. If a Jeremiah would have stood up to explain the imprudence of the “originate and distribute” banking model—i.e. extend credit to anyone then pass it on to a greater fool (for a commission)—that person would soon have been banished from eyesight or paid no mind.

But what is interesting about the FT article is the (I assume) rhetorical question posed by the Bank of International Settlements (BIS): “How could problems with subprime mortgages, being such a small sector of global financial markets, provoke such dislocation?” The BIS is “an international organisation which fosters international monetary and financial cooperation and serves as a bank for central banks.” Surely if anyone in the world knows the answer to that question, it is the BIS. But I doubt their attempt to propose a reason for the financial upheaval gets to the root of the problem. As far as I know, all central banks (and by extension the BIS) promote and endorse the current monetary arrangements, which is the source of our troubles. As I mentioned in my last post concerning unrealistic assumptions, central bankers operates under the premise that our fiat monetary system is sacred. Nothing can be further from the truth.

Undoubtedly, financial institutions deserver their fair share of the blame. However, despite the recent statement of innocence by Mr. Alan Greenspan, Anna Schwartz, a distinguished economist, aptly commented that the Central Bank’s policy from 2003 to mid-year 2004 “was too accommodative. [Interest] rates of 1 per cent were bound to encourage all kinds of risky behavior.” A rational market participant encountered with the option to use funds at a rate less than the inflation rate will almost always borrow to consume or invest. In short, this is exactly what transpired after 2001: excessive money creation (another way to say “lower interest rates”), led to below-market interest rates, leading to all sort of ill-advised behavior (i.e. moral hazard). The way it worked is as follows. When printed money enters a bank, part of the deposit gets multiplied as it moves along the banking system by way of loans. This is what’s called the multiplier effect. For example, bank A gets money from the central bank and will extend credit to one of its customers (say, to buy a house), that customer will make payment to bank B’s customer by depositing it in his/her account. Since Bank B (all banks in fact) has to keep a fraction of all deposits at hand (in the U.S. this equals to 10%), the remaining amount (90%) of the funds is lent to another customer (who maybe wants to buy a house too). This process is repeated over and over. As you can note, from a one time injection of printed money, more is created out of nothing when portions of it move from bank to banks.

What I have just explained is referred to as the fractional reserve banking system. Bankers love this model because it’s a free lunch: they get to use money (created out of thin air) and earn interest on it. Note that banks did nothing to get this money, but rather it was given to them by the central bank. The trouble with this banking system is that if a majority of a bank’s customers decides all at once to withdraw their deposits, the bank will immediately become insolvent because it does not have the sufficient cash to honor the liabilities. This is what recently happened to a major California bank.

Cuts Deeper

But our analysis of the financial crisis does not end there. The loans extended by the banks were bundled in off-balance sheet companies (aka special purpose vehicles), which then issued securities from them to be sold to investors. Some investors then repackaged those securities into other newly created special purpose vehicles of their own, and subsequently issued more securities that were sold to other investors. This process was repeated several times, each occasion generating toxic products with names like CDOs, CPDO, and others that few knew really what they were. At the same time, investors (e.g. hedge funds, private equity, etc) leveraged their exposure in these instruments by borrowing from other financial institutions, some of which were the same ones who created the aforementioned abstruse products. A lot of money was made along the way, of course. Human nature being what it is, everyone eagerly chased yield and became greedy. Recognizing the incestuous relationships these companies maintained, the system was bound to collapse at the slight notice of trouble.

Most mainstream economists are blind to the fact that every financial crisis and economic bust since the Industrial Revolution has been the result of excessive money creation. In our age, the finger is pointed to the Federal Reserve System. Contrary to what you read in most economic textbooks or in newspapers, central planning, which is what the Federal Reserve is, does not work in a dynamic economy: It always leads to a decline in living standards. In fact, the U.S. experienced its greatest economic expansion without the assistance of a central authority dictating monetary schemes.

So, to answer the original question posed by the BIS, anyone who believes they are getting a free lunch (fiat money) will always do foolish things. The 2003-2007 economic boom was nothing short of sheer fraud. Some people understand that printing money out of thin air is never a good thing. If anyone doesn’t understand why it is so, simply google Zimbabwe, you will find your answer there. So long as the current system is in place we will continue to experience these kinds of debacles: The financial crisis is merely the consequences of the severe capital dislocation experienced during the false economic boom.

More on this to come on future postings….