September 18, 2008
FINANCE houses set out to be monuments of stone and steel. In the widening gyre the greatest of them have splintered into matchwood. Ten short days saw the nationalisation, failure or rescue of what was once the world's biggest insurer, with assets of $1 trillion, two of the world's biggest investment banks, with combined assets of another $1.5 trillion, and two giants of America's mortgage markets, with assets of $1.8 trillion. The government of the world's leading capitalist nation has been sucked deep into the maelstrom of its most capitalist industry. And it looks overwhelmed.
The bankruptcy of Lehman Brothers and Merrill Lynch's rapid sale to Bank of America were shocking enough. But the government rescue of American International Group (AIG), through an $85 billion loan at punitive interest rates thrown together on the evening of September 16th, marked a new low in an already catastrophic year. AIG is mostly a safe, well-run insurer. But its financial-products division, which accounted for just a fraction of its revenues, wrote enough derivatives contracts to destroy the firm and shake the world. It helps explain one of the mysteries of recent years: who was taking on the risk that banks and investors were shedding? Now we know.
Yet AIG's rescue has done little to banish the naked fear that has the markets in its grip. Pick your measure—the interest rates banks charge to lend to each other, the extra costs of borrowing and of insuring corporate debt, the flight to safety in Treasury bonds, gold, financial stocks: all register contagion. On September 17th HBOS, Britain's largest mortgage lender, fell into the arms of Lloyds TSB for a mere £12 billion ($22 billion), after its shares pitched into the abyss that had swallowed Lehman and AIG. Other banks, including Morgan Stanley and Washington Mutual, looked as if they would suffer the same fate. Russia said it would lend its three biggest banks 1.12 trillion roubles ($44 billion). An American money-market fund, supposedly the safest of safe investments, this week became the first since 1994 to report a loss. If investors flee the money markets for Treasuries, banks will lose funding and the contagion will suck in hedge funds and companies. A brave man would see catharsis in all this misery; a wise man would not be so hasty.
The blood-dimmed tide
Some will argue that the Federal Reserve and the Treasury, nationalising the economy faster than you can say Hugo Chávez, should have left AIG to oblivion. Amid this contagion that would have been reckless. Its contracts—almost $450 billion-worth in the credit-default swaps market alone—underpin the health of the world's banks and investment funds. The collapse of its insurance arm would hit ordinary policyholders. At the weekend the Fed and the Treasury watched Lehman Brothers go bankrupt sooner than save it. In principle that was admirable—capitalism requires people to pay for their mistakes. But AIG was bigger and the bankruptcy of Lehman had set off vortices and currents that may have contributed to its downfall. With the markets reeling, pragmatism trumped principle. Even though it undermined their own authority, the Fed and the Treasury rightly felt they could not say no again.
What happens next depends on three questions. Why has the crisis lurched onto a new, destructive path? How vulnerable are the financial system and the economy? And what can be done to put finance right? It is no hyperbole to say that for an inkling of what is at stake, you have only to study the 1930s.
Shorn of all its complexity, the finance industry is caught between two brutally simple forces. It needs capital, because assets like houses and promises to pay debts are worth less than most people thought. Even if some gain from falling asset prices, lenders and insurers have to book losses, which leaves them needing money. Finance also needs to shrink. The credit boom not only inflated asset prices, it also inflated finance itself. The financial-services industry's share of total American corporate profits rose from 10% in the early 1980s to 40% at its peak last year. By one calculation, profits in the past decade amounted to $1.2 trillion more than you would have expected.
This industry will not be able to make money after the boom unless it is far smaller—and it will be hard to make money while it shrinks. No wonder investors are scarce. The brave few, such as sovereign-wealth funds, who put money into weak banks have lost a lot. Better to pick over their carcasses than to take on their toxic assets—just as Britain's Barclays walked away from Lehman as a going concern, only to swoop on its North American business after it failed.
The centre cannot hold
Governments will thus often be the only buyers around. If necessary, they may create a special fund to manage and wind down troubled assets. Yet do not underestimate the cost of rescues, even necessary ones. Nobody would buy Lehman unless the government offered them the sort of help it had provided JPMorgan Chase when it saved Bear Stearns. The nationalisation that, for good reason, wiped out Fannie's and Freddie's shareholders has made it riskier for others to put fresh equity into ailing banks. The only wise recapitalisation just now is an outright purchase, preferably by a retail bank backed by deposits insured by the government—as with Bank of America and Merrill Lynch, Lloyds and HBOS and, possibly, Wachovia with Morgan Stanley. The bigger the bank, the harder that is. Most of all, each rescue discourages investors from worrying about the creditworthiness of those they trade with—and thus encourages the next excess.
For all the costs of a rescue, the cost of failure to the economy would sometimes be higher. As finance shrinks, credit will be sucked out of the economy and without credit, people cannot buy houses, run businesses or as easily invest in the future. So far the American economy has held up. The hope is that the housing bust is nearing its bottom and that countries like China and India will continue to thrive. Recent falls in the price of oil and other commodities give central banks scope to cut interest rates—as China showed this week.
But there is a darker side, too. Unemployment in America rose to 6.1% in August and is likely to climb further. Industrial production fell by 1.1% last month; and the annual change in retail sales is at its weakest since the aftermath of the 2001 recession. Output is shrinking in Japan, Germany, Spain and Britain, and is barely positive in many other countries. On a quarterly basis, prices are falling in half of the 20 countries in The Economist's house-price index. Emerging economies' stocks, bonds and currencies have been battered as investors fret that they will no longer be "decoupled" from the rich countries.
Unless policymakers blunder unforgivably—by letting "systemic" institutions fail or by keeping monetary policy too tight—there is no need for today's misery to turn into a new Depression. A longer-term worry is the inevitable urge to regulate modern finance into submission. Though understandable, that desire is wrong and dangerous—and the colossal success of commerce in the emerging world (see article) shows how much there is to lose. Finance is the brain of the economy. For all its excesses, it allocates resources to where they are productive better than any central planner ever could.
Regulation is necessary, and much must now be done to improve the laws of finance. But it must be the right regulation: an end to America's fragmented system of oversight; more transparency; capital requirements that lean against booms and flex with busts; supervision of giants, like AIG, that are too big and too interconnected to fail; accounting that values risks better and that everyone accepts; clearing houses and exchanges to make derivatives safer and less opaque.
All that would count as progress. But naive faith in regulators' powers creates ruinous false security. Financiers know more than regulators and their voices carry more weight in a boom. Banks can exploit the regulations' inevitable blind spots: assets hidden off their balance sheets, or insurance (such as that provided by AIG) which enables them to profit by sliding out of the capital requirements the regulators set. It is no accident that both schemes were at the heart of the crisis.
This is a black week. Those of us who have supported financial capitalism are open to the charge that the system we championed has merely enabled a few spivs to get rich. But it helped produce healthy economic growth and low inflation for a generation. It would take a very big recession indeed to wipe out those gains. Do not forget that in the debate ahead.