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Special report A special report on the future of finance Wild-animal spirits Jan 22nd 2009 From The Economist print edition Why is finance so unstable? Illustration by S Kambayashi WHEN people look back on a bubble, they tend to blame the mess on crookery, greed and the collective insanity of others. What else but madness could explain all those overpriced Dutch tulips? With hindsight, today's mortgage disaster seems ridiculously simple. Wasn't it the fault of barely legal mortgage underwriting, overpaid investment bankers and the intoxication of easy credit? Yet there is an element of the madhouse in that explanation too. Cupidity, fraud and delusion were obviously part of the great bust. But if they are the chief causes of bubbles--which have repeatedly plagued Western finance since its origins in the Italian Renaissance--you have to suppose that civilisation is beset by naivety and manic depression. In fact, observes Abhijit Banerjee, an economist at the Massachusetts Institute of Technology, a little irrationality goes a long way. When reasonable, self-interested people trade with each other, optimism tends to breed optimism--until it subsides into corrosive pessimism. In the words of Willem Buiter, of the London School of Economics, "finance is a scary, inherently unstable, essential activity." Financial services are different from other industries, if only because so much of the business is writing bets. One side pays the other for a claim that comes good if, say, oil prices fall, or a company defaults on its bonds, or householders make their mortgage payments on time. When people talk about losses in finance, they are often thinking about only one side of these contracts. In fact, for every loser on a credit-default swap, for example, there is a corresponding gainer. These are bets, remember: if the punters are down, the bookies are up by the same amount. The winners' extra spending may not offset the losers' retrenchment. And the losers may not be able to afford to pay out, either because they do not have the money--they are insolvent--or because they cannot easily raise the money--they are illiquid. This "counterparty risk", which grows with the volume of bets, has been the outstanding feature of this crisis. American International Group (AIG), once the world's biggest insurer, was bailed out by the American government when it became clear that it would not be able to honour its vast one-way bets on financial stability. Had AIG failed, the banks on the other side would have been in trouble. Although the market netted to zero, it was poised for disaster. Infectious optimists In a boom there is every chance that the betting will get out of hand. Expansion in most businesses is held in check by the need to build assembly lines, rent retail space or hire workers. By contrast, financial contracts can be written almost instantaneously and without limit. Whenever issuers compete for market share or buyers pile in because they are afraid of missing the boat, a boom may be in the making. Investors herd together in this way because, as John Maynard Keynes argued, they do not have a sure grasp of the future. Faced with uncertainty, they resort to whatever conventions they can find to cling to, from popular wisdom to new theories. In a boom, overconfident investors take on bets that they later find themselves unable to discharge. Conventions are one reason why the appetite to buy financial assets tends to feed on itself (see chart 2). In textbook markets for goods, price increases lead to a fall in demand and to substitution. By contrast, rising asset prices tend to be seen, within limits, as a cause to buy. People take rising share prices as a sign of confidence and a reason to put money into their retirement accounts or mutual funds. More recently, falling prices have been taken as a signal to flee, even though shares are much cheaper than they were not so long ago. Asset prices pull themselves up by their own bootstraps. As houses become more valuable, house owners feel richer. If they then spend more, companies make more money, which in turn increases the value of shares and bonds. Lenders are therefore willing to lend more on easier terms. This extra credit makes asset markets liquid: if ever you need to sell something, there always seems to be a ready buyer. Ample credit also tends to feed into spending and asset prices. For as long as people are optimistic, the creation of credit is hard to restrain. Although banks are usually happy to join in, they do not have to be involved, at least for a while. In the boom in Kuwait between 1977 and 1982, people started to use post-dated cheques to pay for shares and property. According to Kindleberger, the value of these circulating IOUs peaked at some $100 billion, a far larger sum than was kept on deposit in the banks. Similarly, when the economy does well, borrowers want to take on more debt. Not only are managers ambitious to expand, but shareholders tend to encourage them. That is partly because in a boom they think it is a low-risk way to increase the return on equity. It is also because the burden of larger interest payments leaves managers with less scope to fritter away cash on pet projects that may not benefit their shareholders. Things that go pop Manifestly, this virtuous circle does not operate unchecked. Potential bubbles often collapse early and harmlessly because fundamental forces are pulling in the other direction. Investors, torn between being late and being wrong, are restrained by rules of thumb, such as historical analogies and price-earnings ratios for shares. Their optimism is continually buffeted by scares and speculators who test whether a rising market is robust. The authorities carry out their original duty, to watch over the banking system, and they can use their newer powers by raising interest rates to damp down spending and borrowing. However, bubbles sometimes get out of hand, and if they do, at some point they will stop inflating and start deflating. A failed airline buy-out finished the debt-fuelled boom at the end of the 1980s; The more efficient the financial system, the faster fear will spread. As asset prices fall, people spend less and investors foreshadow lower profits and higher defaults by running from corporate bonds and shares. When investors lose confidence that other people will honour the promises that underpin financial assets, they retreat to government bonds, cash or gold, which are more dependable. Liquidity and credit suddenly become scarce and a devastating, value-destroying uncertainty takes hold. In 2007 Dick Fuld, the former head of Lehman Brothers, observed that whereas credit grows arithmetically, it shrinks geometrically. Investors take all sorts of precautions to ensure that the people they deal with will honour their promises. They demand regulation and accurate accounts that price assets at market values; they want loans to be backed by collateral and covenants; they ask specialist agencies to rate borrowers' creditworthiness; Such safeguards, essential as they are in policing individual lenders, tend to feed greed in greedy times and fear in fearful ones. Chart 3 shows how lenders to banks registered alarm after Lehman collapsed in September last year. So worried were they about the risk of being wiped out in a bankruptcy or a state rescue that they suddenly started to demand that banks hold much more capital against their assets. For decades this ratio had been stable, below 10% of book assets, though it was over 50% in the 1840s, when banks were apt to fail more often. Nobody can be sure how much capital shareholders now want banks to hold, but Alan Greenspan, a consultant these days, thinks the figure could have grown to 15% of their assets. If so, the banks will have to raise money and sell loans and securities even as politicians are asking them to lend more. Investors' desire for extra protection has made the contraction of credit worse. As the number of defaults falls in the boom, borrowers' credit ratings improve, assets are highly valued and lenders accept a broader range of them. In the bust many borrowers have had to ...
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