Sunday, 12 October 2008

The fall in asset prices is causing the liquidity crisis, not the liquidity crisis the fall in asset prices - by John Ross

The following article appeared on the blog Key Trends in the World Economy

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The announcement that the US government is to follow the example of the British government, and buy shares in US banks in order to recapitalise them, brings to the fore one of the most important issues in the present financial crisis -one which has major financial and policy implications.
The international financial crisis is at present focused in two areas – asset values (share prices, house prices etc) and liquidity (drying up of interbank lending leading to a paralysis of the financial system). But the analysis of the interrelation of these two processes is vital in understanding how to tackle them.
The decisive question is whether it is the fall in asset values that is driving the liquidity crisis, or it is the liquidity crisis that is driving the fall in asset values? Different measures, with hugely different financial implications, follow from the two different answers.
The real cause of the crisis is that assets in the US are overvalued – in the end due to the overvaluation of the dollar. That is, if real market process were allowed to develop, and in the end no one will be able to stop them from operating in some form, these assets will be shown to have less value than their former and present prices.[1]
As these assets devalue down to their competitive market values this weakens, or renders insolvent, the balance sheet of institutions directly or indirectly holding them – that is they suffer loss or bankruptcy.
As these assets fall in value this necessarily produces a liquidity crisis - as financial institutions cannot lend, due to their overstretched balance sheet, nor are they willing to lend to other banks who are also greatly overstrained and may therefore not be able to repay loans. That is, the fall in asset values drives the liquidity crisis.
The present financial crisis logically started in the weakest and most overvalued part of US assets – the sub-prime mortgage market. But it is not confined to them and therefore spreads through other parts of the financial and asset system – the crash of share prices on Wall Street during the last week being the latest manifestation of this.
The policy conclusion that flows from this is that as the assets were overvalued, therefore someone will inevitably suffer loss as a result of their decline - this is unfortunately unavoidable. The only economic question is who will suffer this loss?
The aim of policy must be to ensure that this loss is concentrated as narrowly as possible on the source - that is those institutions most economically responsible for the crisis. If this is not done losses will necessarily spread through the system and those not responsible (viable firms, taxpayers etc) will suffer higher than necessary losses. In this case economic rationality coincides with morality.
This means shareholders in financial institutions which took the wrong decisions, that is who bought/created such overvalued assets, should not receive funds from those who were not responsible. If shareholders in institutions which made wrong decisions are safeguarded then others who bear no responsibility for this failure - viable companies, taxpayers, depositors etc - will suffer corresponding losses.
The government must naturally be prepared to step in to ensure the functioning of the banking system, but it should not be bailing out bank shareholders. This model was used, for example, in the rescue of Swedish banks in the 1990s and was also carried out in the nationalisation of Fannie Mae, Freddie Mac, and AIG in the US and Northern Rock and Bradford and Bingley in the UK. This will involve the state taking over these failing banks to ensure the functioning of the banking system.
Liquidity in this situation will be maintained by two steps. First, immediately, central banks must substitute for the frozen lending markets by themselves lending or using existing nationalised banks to do so – Northern Rock can be used in the UK for this purpose. Second, after nationalisation of the insolvent parts of the banking system, these banks can recommence interbank lending. This route will minimise losses for ordinary depositors, tax payers, consumers, and viable companies.
However consider the policy implications if, on the contrary, it is believed that it is the liquidity crisis which is driving the fall in asset values. In this case the first step is the same – the money markets are flooded with liquidity. But the second step is totally different and will result in losses being spread through the system to taxpayers and viable companies.
If it is believed that it is the liquidity crisis which is driving the fall in asset values then, as the liquidity crisis is overcome through injections of money, assets would rise in value. In particular bank shares will rise in value. It is, therefore, rational for taxpayers money to be put into bank shares, that is to ‘recapitalise’ the banks - indeed it is conceived this may even lead to a profit in the medium term. This is what the UK government proposed and it is now announced the US will follow this. However consider what will occur if this analysis has got the dominant direction of causation wrong – that is that it is the fall in asset prices which is driving the liquidity crisis and not vice versa.
First, despite the liquidity injection, the money put into bank shares will not halt the fall in asset values as this is not being driven by liquidity problems but by a quite other mechanism. Falls in asset values will therefore continue – that is the taxpayer will suffer big losses on the sums put into bank shares (this may be worsened by existing shareholders selling shares at values that have been temporarily artificially inflated by the capital injections). These losses will then make it much harder to indemnify deposit holders, tax payers, maintain public spending, assist viable companies etc – in other words those responsible for the crisis will haved been safeguarded at the expense of those not responsible for the crisis and losses will be spread through the system.
Second, the interbank lending market will have a strong tendency to jam again or to remain jammed – because the downward pressure on asset values means that banks will not be able or willing to start large scale lending. It is quite probable that in the end, to unjam this situation, the banks will have to be nationalised anyway but by this time large amounts of the taxpayers money that had been put in to 'recapitalise’ the banks will have been lost.
The mistake of believing that it is the liquidity crisis that is driving the fall in asset prices, rather than understanding that it is the fall in asset prices that is driving the liquidity crisis, will therefore lead to major losses for the taxpayers and viable companies and also fail to resolve the banking crisis.
To look at the real world, it is quite clear from the facts that it is in reality the fall in asset values that is driving the liquidity crisis and not vice versa. The crisis started in asset values, in sub prime mortgages. This, in turn, revealed that other assets, in the first places the shares and other holdings of US financial institutions, were themselves overvalued. It was this that then created the freezing of interbank lending and the other aspects of the liquidity crisis. In short it is the fall in asset prices that created the liquidity crisis, not vice versa.
Governments will not succeed in overcoming the present situation until they analyse correctly its dominant direction of causation and adopt the appropriate policies.

Notes

[1] This working out of market forces could theoretically take many forms. One, which did not occur, was a gradual devaluation of the dollar over a prolonged period of years. A second would be a sudden drop in the exchange rate of the dollar - that is nominal dollar prices might not fall but their real international value would be cut. A third would be that the exchange rate of the dollar remained the same but that the nominal dollar price of assets fell sharply. But in all cases the price of the dollar denominated assets will fall. Which of these variants occurs depends on other, more short term, factors. In the present phase the dominant process is the third.

2 comments:

Martin Slavin said...

It was with deep dismay that I read this article. My dismay comes from reading the simplistic theories of economic determinism to which Mr Ross clings in his less than rigorous pursuit of a resolution of the economic equivalent of the 'chicken and egg' problem.

He ponders which came first 'the liquidity crisis' or the 'fall in asset prices'. He approaches the problem of the credit crisis in the world's financial markets with the zeal of a roadside mechanic whose car has conked out and in a flash is out the front with the bonnet up wondering whether its a broken fan belt or a leak in the radiator wot dunnit.

He says: ... “the analysis of the interrelation of these two processes is vital in understanding how to tackle them.
The decisive question is whether it is the fall in asset values that is driving the liquidity crisis, or it is the liquidity crisis that is driving the fall in asset values?”

He spots where the origin of the problem lies; “The real cause of the crisis is that assets in the US are overvalued – in the end due to the overvaluation of the dollar.”

He then outlines the danger this 'causes'; “As these assets fall in value this necessarily produces a liquidity crisis - as financial institutions cannot lend, due to their overstretched balance sheet, nor are they willing to lend to other banks who are also greatly overstrained and may therefore not be able to repay loans. That is, the fall in asset values drives the liquidity crisis.”

My problem with his theory is that it depends on a mechanistic determinism of cause and effect which was under scrutiny in the late eighteenth century as being an inadequate description of the downside problems of money markets even before Gauss demonstrated the efficacy of the normal error distribution curve of probabilities in 1809.

Compare Mr Ross's description of the 'cause' of the recent crash to the following:

“According to the academic world view that markets are efficient, only the revelation of a dramatic piece of information can cause a crash, yet in reality even the most thorough post-mortem analyses are typically inconclusive as to what this piece of information might have been. ...Most approaches to explaining crashes search for possible mechanisms or effects that operate at very short time scales (hours,days or weeks at most).

This book proposes a radically different view: the underlying cause of the crash will be found in the preceding months and years, in the progressively increasing build up of market co-operativity, or effective interactions between investors, often translated into the accelerating ascent of the market price (the bubble).

According to this 'critical' point of view, the specific manner by which prices collapsed is not the most important problem: a crash occurs because the market has entered an unstable phase and any small disturbance or process may have triggered the instability.”

From: Why Stock Markets Crash, critical events in complex financial systems, Didier Sornette, 2003

The continued adherence of market makers to the efficacy of the bell curve as a predictive model in spread betting is partly responsible for the mess that these croupiers of 'casino capitalism' have dumped us in today in the view of Nassim Nicholas Taleb;

“Statistical and applied probabilistic knowledge is the core of knowledge; statistics is what tells you if something is true, false, or merely anecdotal; it is the "logic of science"; it is the instrument of risk-taking; it is the applied tools of epistemology; you can't be a modern intellectual and not think probabilistically—but... let's not be suckers. The problem is much more complicated than it seems to the casual, mechanistic user who picked it up in graduate school.

Statistics can fool you. In fact it is fooling your government right now. It can even bankrupt the system (let's face it: use of probabilistic methods for the estimation of risks did just blow up the banking system).”

The standfirst for Taleb's essay; The Fourth Quadrant: a map of the limits of statistics, Nassim Nicholas Taleb, edgedotorg, 15 September 08

Mr Ross then continues his description of the 'effects' which have been 'caused'.

“As these assets devalue down to their competitive market values this weakens, or renders insolvent, the balance sheet of institutions directly or indirectly holding them – that is they suffer loss or bankruptcy. As these assets fall in value this necessarily produces a liquidity crisis - as financial institutions cannot lend, due to their overstretched balance sheet, nor are they willing to lend to other banks who are also greatly overstrained and may therefore not be able to repay loans.”

He identifies problems with bank balance sheets leaving out any description of the 'off balance sheet' scams of complex credit derivatives.

“This area of finance has exploded at such speed that outstanding trades are now put at more than $60,000bn (or, for comparison, 20 times the aggregate capitalisation of London's equity market).” (Gillian Tett, FT, May 30 2008)

This plethora of opaque fictional capital deals were specifically designed to bundle slices of default risks which could be then be traded at a fat fee for the dealers while avoiding banking regulations limiting balance sheet capitalisation ratios.

Having glossed over the real complexity of the problems Mr Ross then uses his crude analysis as the basis for an inappropriate technical economic solution. He underplays the realpolitik of government's quick fix solutions.

The manner in which these are financial solutions which embody political choices about who gets bailed out early on and who eventually pays the costs is vividly described by 'London Banker' in his blog about the motivations behind Henry Paulson's bail out plan which was panicked through Congress :

“....there is no doubt in my mind that this legislation represents the sort of federal largesse for Goldman Sachs, Morgan Stanley, Citibank and JPMorgan Chase that the Iraq war provided for Halliburton and Blackwater.

.....Clearly what is going on here has nothing to do with kick starting the credit markets or stabilising the equity markets or restoring depositor confidence in banks. .....What is going on here is a blatant attempt to provide government funds to a select cadre of firms (not all banks) which are chosen to be the survivors feasting off the carcasses of their less fortunate and less well-connected brethren as the downturn intensifies in the years to come.

This bill is about engineering survivor bias to friends of the Bush administration so that they profit disproportionately from the collapse of these markets using the funds provided by the taxpayer via the unreviewable and unconditional authority of the Secretary of the Treasury.

The crash in equities will still happen. The debt deflation of the economy leading to mass commercial and consumer credit defaults will still happen. The collapse of many national, regional and local financial institutions will still happen. The bankruptcy of many municipalities and shortfalls in state budgets will still happen.”

Financial Eugenics: The Paulson Plan for Survivor Bias, londonbankerdotblogspotdotcom, 2 October 2008

In my view Mr Ross offers a crude and inappropriate technical 'explanation' for this banking and investment crisis. It has emerged from the recent political history of New Labour's continued encouragement of neoliberal economic doctrine personified, in Britain, by Gordon Brown.

This policy has allowed a highly de-regulated space for the City of London's markets in fictional capital . Out of this period, of using low interest rates to turbo-charge the throughput of underpriced credit to stimulate bubbles in overpriced scarce assets, has at last naturally emerged a vast implosion of credit, asset prices, liquidity, confidence, and employment entailed by an unsustainable feeding frenzy.

Lots of experienced analysts, commentators and market traders knew that the crash would happen one day. They were just not sure when it would strike. Many experienced participants in financial management also knew that when it happened the government would be forced to cover the losses.

This is the moral hazard which helped to jack up brokerage fees and bonuses. These are a kind of personal insurance policy to allow the Masters of the Universe to be able to slip away through the social wreckage to privileged places of ease, comfort and retirement.

Gordon Brown's satisfaction at producing a clever sticking plaster fix for the crisis is now a hostage to fortune as the targeted banks set about back-engineering his policies.

“Britain’s largest banks are pressing the government to rethink the terms of its £37bn bail-out of the industry as investors take fright at the requirement for the banks to stop paying dividends to shareholders.

Bank executives have told ministers that the conditions attached to the preference shares, which pay a fixed interest rate of 12 per cent and cannot be redeemed for five years, will encourage the banks to rein in their lending – the opposite of what the bail-out plan is designed to achieve.

Executives are also pressing the government to allow them quickly to replace the preference shares, either by selling assets or by raising additional capital from private investors.

Ministers have so far resisted the pressure, arguing that RBS, HBOS and Lloyds signed up to the scheme voluntarily. Officials also believe it is right that the bail-out should impose a cost on the banks’ shareholders.”

UK lenders in plea to lift ban on dividends, By Peter Thal Larsen, George Parker and Jane Croft, FT, October 14 2008

I will leave the last words to Naom Chomsky:

“Financial liberalisation has effects well beyond the economy. It has long been understood that it is a powerful weapon against democracy. Free capital movement creates what some have called a "virtual parliament" of investors and lenders, who closely monitor government programmes and "vote" against them if they are considered irrational: for the benefit of people, rather than concentrated private power.

Investors and lenders can "vote" by capital flight, attacks on currencies and other devices offered by financial liberalisation.”

Anti-democratic nature of US capitalism is being exposed, Naom Chomsky, Irish Times, October 10, 2008

Alun Griffiths said...

Back to Christopher Caldwell in the F.T. "Which do we want, prosperity or democracy"
Both actually Chris, if I can call you Chris. + happiness.
That should do.