the corner office

Putting it in perspective. What caused it and where to from here? A collection of links to stuff I've read this weekend.

Not everyone is in trouble. Canada missed some of the pain:

The main reason for optimism here is the banking system. Experts here note that Canadian banks are more tightly regulated, more liquid and less highly leveraged. Instead of being highflying investment banks, they tend to operate in a more traditional manner, with large numbers of loyal depositors and a more solid base of capital. ... Strict rules also govern mortgage lending. By Canadian law, any mortgage that will finance more than 80 percent of the price of a home must be insured. Two-thirds of all Canadian mortgages are insured by the quasi-governmental Canadian Mortgage and Housing Corp. As a result of the tough standards for insurance, "people tend not to get mortgages they cannot afford"...

Another difference is that in Canada, mortgage interest is not tax-deductible, making it harder to buy a house. As a result, Canada did not have as strong a construction surge as the United States did during the boom years, and thus does not now have a big oversupply... People do not take out mortgages just for the tax break. In Canada, "a mortgage is seen as something you want to get rid of as fast as possible," said Peter Dungan, an economist with the Rotman School of Management at the University of Toronto.

I can't be bothered to find a link, but I believe that South Africa has been somewhat protected from the crisis, in part for similar reasons.

Anna Schwartz, 92, a respected economist and expert on the Great Depression:

To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates... This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

In other words, bank lending patterns are now reflecting the perceived risk of lending to other banks (and to the public, for that matter). You could argue that bankers haven't been so good at their jobs recently, but you'd expect that these bankers have more inside info and a better handle of the state of affairs in the banking sector than politicians do. Schwartz goes on to say:

... "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."

It's harsh but the net cost of doing so, compared to bailouts, is quite possibly lowest of all the alternatives. But it just isn't politically feasible. The truth is that the governments aren't really trying to find the best solution to the financial crisis, they're trying to be seen to be providing the best solution. Once they've 'acted' and done enough for it to look like the immediate crisis has dissipated, enough to get voters off their backs, the on-going costs of poor decisions will simply be recovered from tax-payers and more government borrowing for years to come. By then the direct connection between the bailout and its eventual costs will have been blurred, and anyway; that'll be another government's responsibility.

Finally, Tyler Cowen:

Over all, then, the three fundamental factors behind the crisis have been new wealth, an added willingness to take risk and a blindness to new forms of systematic risk. All three were needed to bring about the scope of the current mess — so that means we’ve had some very bad luck on top of everything else.

Cowen's co-authored blog, Marginal Revolution, is one I've started following again since the crisis hit. Cowen is a libertarian-leaning economist, but the community of economist bloggers that Marginal Revolution forms a part of, generally engages in pretty reasoned discussion - high on lucid analysis, theory, data, facts and respect for differing academic views, and low on rhetoric.

I'm not an economist. I lean strongly towards classic liberalism and free markets, so my view is biased. Regardless, I don't think it can be denied that government intervention has at the very least amplified market failure, and much of the meddling will only prolong the crisis or in many ways make things worse.

A common principle emerging from much of what's now being written by economists and people in the know is this: banks and institutions took on too much risk. They gave away money without fully considering (or then disclosing, often because they themselves did not know) the risk of not getting it back. That risk-taking was only partly stupidity and greed on the part of rich bankers, as the media likes to portray it - the risk-taking was encouraged by governments riding high on housing booms, loose margin requirements for banks (also government), monetary policy which kept interest rates too low (also government), shareholders who demanded that their companies got a piece of the action, and people spending well beyond their means on homes and luxuries in general.

The question is - will policies and the inevitable regulation that will now follow recognise that it's about making transparent and properly pricing risk, and if that costs too much in terms of economic hardship or political debt, will governments have the will to do it?

I'll end with this quote, which gets to the heart of things, from Warren Buffet (via):

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

The falling share prices mean that for every share being sold at a deflated price, someone else thinks that share is fairly or undervalued, and is willing to buy it. Many people predicted this crisis (if not the scale). There are many losers, but the prudent and the patient, those who managed their risk properly, and prepared for this, will be doing just fine. There's a lesson to be learned from them.