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Anthony de Jasay

A Trillion-Dollar "Catastrophe"?

Anthony de Jasay*

The French socialist and corporate lawyer, Dominique Strauss-Kahn, as Director-General of the International Monetary Fund, has joined the chorus of financial leaders calling for "something" to be done to solve the current banking crisis brought on by the American subprime lending "crisis" which came to a head in August 2007. He has used his position as the head of one of world's leading financial institutions to utter shrill statements about the "crisis" being grave, very grave indeed, with the worst yet to come. At the IMF, World Bank and G7 meeting in April 2008, the British Chancellor of the Exchequer went one better, claiming that we were witnessing the greatest economic shock of the last seventy years. The 1973-74 oil shock, the double-digit inflation of the 80s ending in the sharp 1991-92 recession, let alone the massive destruction of human and material capital in World War II must have slipped from his mind.

One might also distinguish between previous financial problems, such as Argentina's bankruptcy in 1998 and Turkey's overheating in the first years of this century, which are the sort of balance-of-payments problem that might both require and merit lending to it by the International Monetary Fund, and other "crises" which are the result of the loss of confidence in the market. The current "crisis", as every opinion-maker persists in calling it, is primarily the latter kind, one of loss of confidence. Financial markets are inherently skittish. However, every market, even skittish ones, have self-healing capacities and the more highly developed they are, the more reliably these capacities restore a market to equilibrium. Cool and masterful action by central banks can be an additional help. What does not help is voluble and excited talk by authorities who should know better than stir up panic among banks and institutions under their tutelage who are frightened enough without being told that Judgment Day is nigh.

Nor is it helpful for the self-healing process that greater and lesser authorities and indeed all self-appointed experts who manage to get quoted in the media keep calling for "coordinated global action", though there is no chance whatever of such a thing even if it meant anything specific. Trying to stave off the havoc they imagine to loom on the horizon, they sow the panic that might make it into a real danger. Draconian FASB accounting standards force financial institutions to mark down certain types of assets in ways that undermine such market prices they might otherwise reasonably command, and thus create a need for further cumulative markdowns. Under public pressure to "show it all", banks are deprived of the discretion that commonsense "prudent man" conduct would leave them. Looking weaker than they really are, and anticipating tighter regulation, they feel vulnerable to loss of confidence of their depositors and of the interbank market, and restrict lending. All in all, busybody babble, officious interference and the urge to impose order on passing turbulence, are helping to bring about the very effect they profess to dread. After the 1929 crash, much the same administrative ineptitude and busybodiness, plus a suicidal attack of trade protectionism, helped to deepen and prolong the Great Depression. That chapter of history is quite unlikely to repeat itself, but some high officials and august institutions seem to be having a good try at making it do so.

The IMF now estimates the losses from the "subprime" mortgage mistakes at $565 billion and from its secondary effects at another $380 billion, or a total of $945 billion. As they are presumably still counting, one might safely round the total to one trillion dollars. The sum does sound catastrophic, and the media chatter does present it as such. It is not. If it were really a loss to the world economy, it would be a bit of a shock, but not a catastrophic one. However, most if not all of the trillion dollars is only a loss to one side in a zero-sum game; it is a gain to the other side. If the mortgagee lends too much on a house to the mortgagor, the latter gains what the former loses; the house itself suffers no material damage. If the mortgagee escapes the loss by having the mortgage "packaged" with many others in a "collateralised debt obligation," that is passed on to some institutional or private buyer, it is the buyer who takes the loss if some of the mortgages in the CDO turn out to be worth less than their face value. There may be a whole chain of buyers sharing in the loss. Some in the chain may even gain. The whole process of securitising a mortgage serves to transform it into marketable form, so that various cocktails of mortgages end up in hands that are willing to carry a given default risk for the lowest payment and are also willing and able to assess the risk. It is on the latter score that much error and negligence occurred because the old adage of caveat emptor was taken too lightly. If there is a remedy against that, it is not more severe regulation of financial transactions, but the painful lesson taught by burnt fingers.

Needless to say that even a zero-sum game can have substantial economic effects if the gains and losses, though cancelling themselves out, are big enough. The resulting redistribution of the stock of wealth, however, is partly a matter of luck and its effects must be a matter of guesswork. What is fairly predictable, though, is the impact of the event itself that triggers off the "trillion-dollar catastrophe" in the first place. In the "subprime" context, the event was the downturn in business and residential property prices in the US, the UK, Spain and Ireland. Besides hitting those who bought or lent on property and benefiting those who sold or mortgaged theirs just before the downturn, property owners as a whole suffered a paper loss on their holdings, as did owners of equity securities in the ensuing stock market decline in late 2007 and the first part of 2008. This "wealth effect" on spending is no doubt negative, but it is hardly catastrophic and given the puny personal savings ratios in the US and the UK, somewhat slower consumer spending may not be an unmixed evil.

However, the jump from predicting mundane and ultimately quite moderate economic changes to apocalyptic visions is a long one. Mr. George Soros is certainly one of the most successful speculators of recent decades; his long and spectacular run of winning bets must owe more to talent than to blind luck. His repeated attempts at earning intellectual fame with books explaining financial markets in near-mystic terms are on the whole less successful. He likes to conclude that capital is too mobile for its and the economy's own good, that financial movements are self-reinforcing and self-destructive rather than self-equilibrating and that more and better regulation is imperative. In his latest book, The New Paradigm Of Financial Markets: The Credit Crisis Of 2008, he lays great stress on the danger of a swelling volume of credit derivatives. He puts the outstanding volume of credit default swaps at $45 trillion, since he wrote his book, they have risen to $62 trillion (yes, 62,000 billion). But despite the implied suggestion of an exploding economic universe, the astronomical number need not frighten us. These swaps are in essence bets on loans and bonds being or not being duly repaid. Every bet made on some outcome is necessarily matched by a bet taken on it. A given outcome has no effect on net wealth, though it does redistribute it. Banks should normally be net winners of the process just as bookmakers are net winners at the races, except when they act as punters. Some banks apparently did so act recently, and their bets did not pay off. However, none crashed and no depositors lost their deposits.

The redistribution of wealth engineered by credit and equity derivatives is voluntary, for it is the result of every 'player' freely taking the risk he runs to earn some expected reward. Public opinion, the media and the authorities condemn this voluntary redistribution with horrified indignation. Involuntary redistribution by taxation, on the other hand, earns overt or at least tacit approval.

Meanwhile, after the trillion-dollar horse has bolted, preparations are in full swing to lock the stable door. Banks have just about adjusted to Basle II regulators, and will apparently soon be confronted with proposals for a new set of more stringent constraints. One characteristically paternalistic object would be to make sure that there will never again be a trillion dollar loss to the system and never mind the trillion dollar gain. It is to be feared that such new regulations would induce dis-intermediation and hence hinder efficient outcomes. This adverse effect, however, might last only as long as it took all interested parties to learn to get round the regulations. Even the cleverest regulation is no real substitute for the more flexible and discretionary common sense of the "prudent man" rules that financial institutions must observe in order to build and preserve the reputations upon which their future livelihood essentially depends. It is not more regulation but less that would spur confidence-dependent financial institutions to follow the "prudent man" rules, each in its own fashion, flashy or staid to suit client preferences and needs, be they flashy or staid.


*Anthony de Jasay is an Anglo-Hungarian economist living in France. He is the author, a.o., of The State (Oxford, 1985), Social Contract, Free Ride (Oxford 1989) and Against Politics (London,1997). His latest book, Justice and Its Surroundings, was published by Liberty Fund in the summer of 2002.

The State is also available online on this website.

For more articles by Anthony de Jasay, see the Archive.
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