Monday, October 8, 2007

Financial Crises: Over-reacting to Over-reactions

Scanning through uber financial historian Harold James recent piece, at least two thoughts come to mind.


In most cases, history's lesson is that the risks that are not watched are the ones that get out of hand.
I don't think all financial crises are 'unknowable'. It may simply be that they are unpreventable. This seems to me the conclusion that Alan Greenspan came to following his 'irrational exuberance' speech, following which he was severely browbeaten by Wall Street.

Most financial crises are happening in plain sight. The ability of Wall Street to manufacture junk credit may be put under the rubric of "financial innovation", or one could find a more descriptive name. It doesn't seem to fall in line with something like checking accounts or consumer credit cards. Ranking CDO's as investment grade when maybe they weren't doesn't seem to count as "innovation" or "innovation related", does it?


In many cases, history's lesson is that the risks that are not watched are the ones that get out of hand. The most telling tidbit from Greenspan's recent testimony isn't that the Board didn't know about the risks of sub-prime. Clearly, they did (even by admission). Theoretically, one approves of such things (I do). But the sub-prime market, as an innovation, had been through 'tough times' before, with so-called "manufactured home" defaults, among at least two cycles (that I know).

No, the most telling tidbit is that they didn't realize the magnitude of the lending that was going on. This was partly because those doing the lending were outside the ambit of those doing the watching. In other words, Q.E.D.


Many, if not most, crises involve some sort of panic, which one might describe as "accelerating risk aversion".

It's important that the financial systems themselves do not contribute. Orderly markets should be maintained, if they can be. There are things 'to do' to make that possible.

Fear feeds on lack of transparency, which lends itself to rumor and exaggeration. Efforts to put a floor under the market, to make key variables transparent (like coming clean on the size of problems or the details of risk-burden sharing, etc.) are things to do.

Betting on one side, as many central banks have tried to do during currency crises, for example, might be a waste. Same for maintaining artificial (non-economic) restraints or props, like the gold standard.

Sometimes shutting down the markets has proved to be workable. The redux of the Asian financial crisis smiled favorably on Malyasia, who shut down currency speculation in a anti-liberal way. In Hong Kong, they monetized the market in order to protect values from panic. That might seem like medicine that would kill you, but one can see positive effects. Which suggest that savvy is part of the equation, as much as some would like an on-balance assessment for ... being impervious to crisis.

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