An Explanation of the Current Financial Crisis

This past weekend's summit of world leaders in Washington represents another step in the painful process of fixing today's financial crisis. As our leaders go about this formidable task they would be well advised to consider some of the unintended consequences of previous attempts to fix credit crunches, and how some of those 'fixes' inadvertently contributed to today's problems.

The first lesson concerns the dangers of state subsidised lending, a story that goes right back to the Great Depression. Back in the 1930s the American economy was, as it is now, caught in a debt deflation resulting from a failure of the private sector banking system to provide affordable mortgage funding to ordinary American families. One of the fixes for this problem was the establishment of Fannie Mae the state backed agency whose job it was to buy mortgage loans on behalf of the government, thereby providing credit to the moribund housing market. This neat idea is exactly what is needed now to help restart today's mortgage market and is not far removed from the originally proposed TARP plan. Unfortunately however we are not in a position to deploy the Fannie Mae fix. Somehow someone forgot to turn off the subsidy when it was no longer needed and as a result Fannie Mae continued accumulating mortgages throughout boom years of this and previous decades and in doing so helped magnify the mortgage bubble. Ironically at just the point when Fannie Mae should be stepping back into the mortgage market it is instead requiring its own bailout. An institution which helped fix the first Great Depression inadvertently helped generate what may yet become the second Great Depression.

The second lesson concerns the dangers of state managed exchange rates. After World War II the Bretton Woods system of pegged currency exchange rates was used to fix the problem of competitive currency devaluations. More recently a similar arrangement, now referred to as Bretton Woods II, has been used by China and other developing countries to fix the problem of emerging market currency crises.

Initially both the original Bretton Woods system and today's emerging market currency pegs were mutually beneficial; Bretton Woods I accelerated the re-industrialisation of Europe and Japan after WWII and lately Bretton Woods II accelerated the industrialisation of China and other emerging economies. But in both cases as the industrialising economies caught up with the American economy the pegged exchange rates became increasingly inappropriate.

By the 1960s the economic output of Europe and Japan had significantly caught up with that of America but their currency valuations had not kept pace with this progress. As a result America began sending a flood of dollars abroad to buy their cheap goods. Ordinarily this outflow of American dollars would have depressed the value of the US dollar and corrected the trade imbalance. Instead, due to the fixed exchange rate agreement, foreign countries automatically recycled their trade surpluses back into America to prevent the dollar from falling in value. Today the same arrangement is replicated particularly with the pegging of the Chinese currency. Unfortunately while the currency pegs remain in place any amount of American borrowing from abroad is automatically matched, dollar for dollar, with foreign lending. In both the sixties and in this decade this arrangement allowed and encouraged America to accumulate what ultimately became an unserviceable debt burden.

The pegging of exchange rates was a cure for currency crises but the cure became cause of subsequent debt crises. This arrangement is particularly problematic when the pegged exchange rates are between countries with significantly different rates of economic growth.

The third lesson concerns the dangers of the state trying to over manage economic cycles. In the 1990's the Federal Reserve adopted a 'risk management paradigm' as described by Alan Greenspan in 2003: "At times, policy practitioners operating under a risk-management paradigm may be led to undertake actions intended to provide some insurance against the emergence of especially adverse outcomes. For example, following the Russian debt default in the fall of 1998, the Federal Open Market Committee (FOMC) eased policy despite our perception that the economy was expanding at a satisfactory pace and that, even without a policy initiative, was likely to continue to do so." In other words, the Fed began using monetary policy not reactively in response to economic crises but proactively to prevent crises.

The risk management paradigm was tremendously successful at heading off, or significantly moderating, recessions, so much so that economists began talking of 'the great moderation,' as described by the then Fed governor Ben Bernanke in 2004: "One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility. ...Several writers on the topic have dubbed this remarkable decline in the variability of both output and inflation 'the Great Moderation'."

Unfortunately those using the risk management paradigm to prevent crises failed to heed the message of great economist Hyman Minsky who famously warned: 'stability creates instability'. As the Fed became more adept at pre-empting crises households became accustomed to greater certainty of income and employment, and with this greater certainty came a greater willingness to borrow. Today's unserviceable household debt is in part attributable the excessive confidence imparted by the Fed's over management of previous economic cycles.

Individually each of these stories has a specific lesson our leaders: state subsidies of lending should last only as long as absolutely necessary; free trade of goods and capital is a marvellous idea but only when accompanied with equally free exchange rates; the occasional recession provides a painful but essential economic discipline.

Collectively these stories suggest two additional lessons. Firstly, when seeking to apportion blame for this crisis our governments and central banks should be willing to examine their own role as critically as they are now judging the private sector financial system. Secondly, history teaches that the fixes we implement today may well generate the problems of tomorrow - temporary solutions may be best.

George Cooper is the author of "The Origin of Financial Crises: Central banks, credit bubbles and the efficient market fallacy" (Vintage Books)