October 12, 2008

The fragility of the market

There is no need to state the obvious: the world's financial markets are in serious trouble. After all, the Dow Jones Industrial Average lost something on the scale of 2000 points within 2 weeks, a fall that probably hasn't had an equal in history. Other stock markets, ranging from Japan's, to Hong Kong's, to Indonesia's, to European stock markets are all feeling the aftershocks. The entire financial structure of the country of Iceland has failed. These times are truly extraordinary: as former Fed Chairman Alan Greenspan proclaims, such a devastation is usually seen only "once in a century".

Why did this happen? After all, it is said that those who do not understand history are doomed to repeat it. And for the sake of the next century (the third time's the charm?), it is necessary to examine why this financial crisis happened.

Though it is difficult to compare this crisis to the Great Depression, due to the differences in how monetary policy was conducted and how money was supported, it is the only event of comparable scale for the current global financial meltdown. Here, a major difference appears: while the Great Depression was the cause of credit being too tight, the initial cause of the current financial crisis was too much loose credit.

Two causes of the current crisis are evident, one of them being more important than the other. The most important cause of the current financial crisis was the Federal Reserve's policy of keeping interest rates incredibly low throughout the 90's. Though it would appear that such a policy seemed justified at the time and helped contribute to the United States' incredible growth during that period, the policies were not reversed quickly enough once the growth began slowing. Indeed, the Fed did what they saw as necessary in keeping interest rates continually low once economic slowdown seemed to arrive. However, with a lack of investment opportunities in new technologies due to the Internet bubble bursting, there was a lot of freely available credit without a lot of places to hand it out.

This changed once Fannie Mae and Freddie Mac were given mandates to provide mortgages to individuals traditionally disadvantaged individuals. The merits of wanting greater equity in home ownership can be debated later. Needless to say, though, that these two reasons led to a massive extension of credit in the housing sector.

A housing bubble has one uniquely devastating affect on the economy. For example, while normal recessions have housing related spending falling first, a housing bubble prevents that. This makes recovery that much harder. More problematic, though, is that the extension of so much credit has drastically changed expectations: bankers expect this much credit to always be available: once it's not, bankers panic, investment greatly falls and the economy slows down.

Now we have a situation in which the Fed is caught between a rock and a hard place: if it continues to extend credit, it preserves the economy but creates a long term effect of an inherently riskier market. If it tries to correct expectations now the world economy could quite literally collapse.

Fortunately, there is a way out. If the world governments start by continuing to extend credit and gradually reduce that credit, then the damaging effects should be mitigated and the world economy can return to normal. If it does not, then economic collapse will not just be a doomsday scenario: it will be reality.

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