Some thoughts on the financial crisis

This being the first post in my new blog, I would like to outline what in my mind is the fundamental issue with efforts currently being undertaken as a response to the current financial crisis, and conclude with an outline of what a more attractive solution might entail.


Financial Crisis
The financial crisis has been going on for quite some time now, despite repeated claims to the contrary by the Paulson - Bernanke fire brigade, and several other bureaucrats in the initial stages of the crisis.

Given that the US administration is soon to to change, it is interesting to note the differing agenda of the current administration, who remain focused on "shoring up confidence" while implementing incoherent and hastily stitched together programs to stop the crisis from worsening, from that of the incoming administration, who appear to be talking up the crisis. Paul Volker's speech at Lombard Street research certainly does little to foster confidence: "What this crisis reveals is a broken financial system like no other in my lifetime". It should be noted that Paul Volcker was alive and kicking during the Great Depression. Whether this is a warning by Volcker to go out and buy canned food or whether this is merely an attempt to pre-empt partisan attacks when the Obama administration proves incapable of solving the mess left by the current incumbents is unclear to me at this time.

However, I do generally appreciate a bit of straight talking regarding this crisis as I tend to get rather worried when I see Central Bank Board members, Professors with substantial reputations, turn in to cheerleaders for the financial system, as experienced at this event. The point being of course that the crisis must be really bad if a member of the Governing Board of the SNB is unwilling to tell you that it is, in fact, really bad.

It appears clear to me as it has for some time now that the current financial crisis is indeed going to be the major historical economic crisis of our time. Deflation appears to be increasing, causing enormous wealth destruction across the globe. The extremely expensive programs to buy up toxic assets and recapitalize the degenerate financial system appear to be largely futile, as banks remain unwilling to provide capital to the real economy. Therefore, it appears inevitable that the situation will get worse before it gets better.

What to do about it?
Problem: The highly overleveraged financial system has produced paper liabilities (to itself) that are so enormous that they can no longer be borne by the financial system.
So far, two main paths have been chosen to solve this problem:

Solution 1: Liabilities will be transferred to the public (Switzerland mostly, initial TARP) so the financial institutions can continue as if the crisis never happened, in the knowledge that the state will always bail them out.

Solution 2: The public invests in financial institutions via equity participation, thus recapitalizing banks and subjecting banks to increased oversight and control by the state. Once the banking system works again, state equity participation will be sold.

To me, solution 1 is certainly the most irresponsible, short term solution imaginable, and signals excessive coziness between Central Banks and the Private Financial system. Indeed, without severe penalties to the financial institutions who seek public capital to operate, the moral hazard involved in this operation is extreme. Solution 2 is far more attractive, as it goes some way to align interests and also control between the investor (the public, i.e. you) and the entity invested in. Banks do not want to be controlled by the state so they will endeavor to become self-sufficient once again as soon as it is feasible, and then try and make sure that they remain independent from state interference.

However, the main problem with both of these approaches is that they do not address the main problem, namely, unsustainable levels of risk taking in the financial system. Both approaches have the aim of financial institution recapitalization, and do so by injecting public capital into supposedly private enterprises, with the implicit goal of reflating the credit bubble so that we can all continue as we have so far. It is widely accepted that levels of leverage prevalent in the system were excessive prior to the crisis. For this reason, attempts to maintain previous levels of credit such as directives to financial institutions in the UK and US to maintain or even expand levels of mortgage lending will not only be extremely expensive, but largely futile. Indeed, such measures will merely postpone the inevitable.

The long term solution will have to focus on maintaining the economy in a state of relative balance by eliminating the excesses which led to the current crisis. It will have to address issues such as the role of state in the markets, moral hazard, government sponsored entities or the problem of being "too large to fail" and most fundamentally, public vs. private risk raking.

I realize that this is quite an undertaking, However, if you decide to follow this blog then maybe I may find the time to attempt an outline of a real, sustainable solution to the problem, one that will hopefully minimize the exposure of the public to financial system excesses.