Prematurely Jumping From the Global Financial Crisis to the End of the World as We Know It

So the financial crisis has definitively moved from being a Wall Street phenomenon featuring a certain amount of European schadenfreude to a global crisis in which European banks are just as involved as American ones.  That it is a global crisis and not merely an American one means two things.  

First, early on in this financial mess, the sense that it was “global” meant that the foolish, bad, overleveraged lending by American banks was really an American problem although the capital that fueled it came from abroad, mostly from Asia and especially China: cheap Chinese goods, as Sebastian Mallaby explained a few days ago in the Washington Post, brought much cash to China which was then recycled back to the rest of the world in the form of asset inflation, which the Fed chose to ignore.  In that regard, the flows of capital were global but the bad lending basically American.

(But we should also emphasize – Mallaby implies it without really discussing it – that the cash mostly didn’t originate in China.  It mostly originated in the United States through loose monetary policy by the Fed, which then went partly directly into the housing markets and partly to China to buy consumer goods, and the excess capital in China flowed back to the US.  The role of the Fed in not taking out excess liquidity following the events of the Asian crisis, the 2000 tech bubble collapse, and the post 9-11 difficulties cannot be noted too strongly.  It’s a global flow in one sense, and a round trip in another.)

Second, however, within the last few weeks (and it was actually clear earlier for those willing to look at UK problems), it has become clear that the crisis is global in the sense that banks in Europe and elsewhere have also loaned on the same super (by historical standards) leveraged terms and bought and traded derivatives with the same difficulties in valuation and so have, on some measures, even greater exposure than their American counterparts.

The problem for Europe, however, is compounded by the amalgamated nature of the political and financial system.  That is, the European Central Bank has the same powers that the Fed has to deal with a liquidity crisis – the ability to flood the system with liquidity in order to persuade the public that there is a lender of last resort willing to lend.  (The problem for the ECB as well as the Fed is that this is only half of Bagehot’s classic advice for central banking – lend freely, yes, but on punitive terms with good collateral (so as to deter moral hazard).  That last part, starting with the “punitive terms,” appears to be less the forthcoming as a matter of policy.)  

But unlike the Fed, the ECB does not have sweeping powers to address the fundamental cause of the liquidity crisis.  Investors and depositors and the general public did not wake up one morning seized with a mass hysteria about safety and soundness.  There is a liquidity crisis because there is, really truly is, a solvency crisis.  The Fed has sweeping powers under the Federal Reserve Act and other legislation, including the bailout bill, to try at least to resolve the solvency crisis – the fact, to start with but not ending there, that the banks are holding toxic paper that is worth far less than recently advertised but worth more than current (un)(anti)(non)(hard to find the precise term) markets, under mark to market accounting, indicate they are worth.  The pieces of paper moved from being thought to have an established distribution of risks to genuine uncertainty.  The point for central banks is that it is a liquidity crisis generated by a solvency crisis, and the former won’t really be resolved until there is some kind of clear path to resolve the latter.

So far as I can tell from a survey of the ECB statutes, it lacks that kind of authority or access to a treasury that would allow it to address the root solvency issues.  If a reader wants to enlighten me otherwise, I would be grateful to hear, but I cannot see it in the literature review I’ve conducted or the friends I have informally consulted.  The ECB must take short term collateral in exchange for providing liquidity as lender of last resort, but that falls short of addressing fundamental solvency.  Which is why European countries, to the extent the issue is being addressed, are having to do so outside the context of the bank and in the context of national ministries of finance which have, in a word, money.  Fiscal institutions of government and not solely monetary ones.  

The European response, therefore, has been to look to the Bank to support the euro and act as lender of last resort.  Its statutory obligation is price stability, and so it has also not (so far; this is likely to change) engaged in easy money policies in the way that the Fed (questionably to my inflation-hawk mind, for what it’s worth) has done with a free hand, and may do even more soon.  The individual countries have, through their ministries of finance and fiscal agencies, sought to put a floor under their own banks.  The difficulty is, of course, that such individual action invites both strategic action on the part of private parties – seeking for example the safety of Irish banks under their total guarantee – or else one economy pushing its costs off onto another economy.  There are huge collective action problems here, especially in a situation in which action needs to take place very rapidly.  Whether the leading European economies can manage to coordinate so as to limit losses in a systematic way remains unknown for now.

Anyone who would like to see what can happen, however, in an almost laboratory case of an economy that came from nowhere, had little else to offer, took up banking as its business as easy global credit hit, and achieved spectacular returns from leveraging loans out everywhere – serving as an epicentre of global leverage – is Iceland.  It is also a textbook example of how leverage is a sword that cuts both ways.  Iceland’s economy, with 340,000 or so people, climbed to the top of the per capita income charts on the backs of its financial services industry.  Its currency got stronger and stronger.  It is all unwinding with the same effect of the higher you climb on leverage, the harder and farther you fall.  The currency is in freefall, and the offer of a sovereign guarantee of the banks doesn’t mean what it might when, in this laboratory of leverage, the banks are several times the size of otherwise national economy.  Eventually the international banks cut off the flow of credit to Iceland.  The currency falls and inflation zooms.  There is no hard currency with which to pay for imports – including food to an island nation whose economy consisted, before financial services, of tourists, fishing, and the occasional whale.  The current likely outcome carries concerns that, in this instance, are as much geopolitical as financial – Russia providing a 4 billion euro bailout!  (Remember, Europe, Russia is your friend in time of need!!  Ouch.)

The crisis in Europe is now prompting questions as to whether the euro itself can survive.  That kind of talk seems to me wildly exaggerated and premature.  The problems are clear – a currency that has a central bank in one sense but not a central fiscal authority, and indeed a whole lot of separate masters, each sufficient to cause mischief but no one big enough either to clean up the mess or to impose a solution on everyone.  However, as with so much of the European Union, the euro is as much a political project as anything else, and so much political capital has been invested in it that it seems utterly fantastical to be entertaining questions of the euro’s demise.  Much more likely would a euro whose multiple policymakers in monetary and fiscal policy cause those who have been considering it as a reserve currency alternative to the dollar to think again.  It is not that the dollar is so attractive – the Fed’s easy money policy, stretching back to Greenspan, puts that in question – but it has a Treasury Department as well as a Federal Reserve, and the existence and coordination of those appears, at this point at least, to be a signal marker in favor of the dollar.

More generally, the sheer breadth and depth of this financial crisis inevitably invites many apocalyptic and highly wrought comments that events of such financial magnitude must surely be signals of deeper international political shifts.  American hegemony is finally ending, this is the rise of Asia or China, etc., etc.  (Consider this from a daily newspaper in Nigeria, for example; or this from the Spiegel; or this from Niall Ferguson in the Washington Post.)  My students, who tended to study political science before law school, frequently want to interpret events in sweeping political and historical terms; they find it easier than the much more dry and technical financial basics such as the holder in due course doctrine.  

But is it not far too early for sweeping geopolitical and historical interpretations?  I had reason recently, in reviewing Paul Kennedy’s 2006 book on the UN (reviewing the recent Spanish translation), to go back and reread Kennedy’s 1987 The Rise and Fall of the Great Powers.  Goodness.  If ever the un-wiseness of speaking too soon in sweeping historical terms were on display, that book is it – appearing, famously, as a tract on American decline just before the collapse of the Soviet empire.  Curiously, the monumentally-comic timing of the book seemed to have no impact on Kennedy’s international reputation; it has been translated into at least twenty-three languages because, I venture, the facts of what happened are less important than awaiting the final triumph of hope over experience.  There is a big gap between the indubitably true proposition that no empire has ever survived forever to the proposition that the American empire, if that’s what it is, is falling now, and we know this because … the Dow has crashed a gazillion points and credit default swaps won’t sell and no one knows for sure what a liquidity put is, and it will cost trillions and trillions to put it all back together again.  Ergo, the days of the dollar as reserve currency are numbered, and from there, it is up to Russia and China (and perhaps Venezuela, save for the fall in oil prices) to pick up the pieces of the international economy – pick up the torch, as it were, from the faltering Americans. 

As Richard Posner pointed out acidly in his book on American public intellectuals a decade ago, there is essentially no reputational cost to scholars who make spectacularly wrong public predictions and, for public intellectuals, all publicity is good publicity.  Gary Becker, it seems to me, is a lot more realistic in his assessment of what this all means, in an opinion piece today in the Wall Street Journal.  The euro is not coming to an end, so far as the actual evidence suggests; the dollar’s role is shifting somewhat in relation to the euro, but it will continue as the main reserve currency for the foreseeable future; if massive political-historical changes in hegemony are now underway, they can surely wait a couple of weeks before predicting them (although part of the novelty market in public intellectualism is to be there first, right or even plausibly, or not).  We might at least wait until after the election.