Friday, February 27, 2009

Was The Financial Crisis Predicted ?

No one could have predicted the current economic crisis with any accuracy or authority. The whole thing has surprised the finest minds in mathematical modeling and finance-as-physics.

Writing in the Financial Times John Kay has helpfully explained that when we consider markets ‘we may be able to say a lot about their general properties while being unable to make specific predictions’. That’s because markets are so dynamic and non-linear and all. You know, that thing with the butterfly and the hurricane.

It’s all very well to carp now, and complain about the excesses of the last decade or three, but it’s better, more mature, more sophisticated, to recognise that what’s done is done, shrug, and move on. After all there is work to be done, and there are belts to be tightened. Someone has to pay for these bailouts.

The trouble is that this is all bullshit. There were plenty of warnings that the build-up of debt was unsustainable. To take only one example, Peter Warburton published a book called Debt and Delusion in 1999. In it he warned that low interest rates and the central banks’ narrow focus on inflation would lead to havoc in the debt markets.

Credit quality was already declining by the late nineties as lenders started to treat all borrowers alike. The normal caution of bankers was allayed by the magic of securitization and the willingness of the banks to lend was matched by the readiness of those on low and middle incomes to borrow.

This growing indifference to risk would inevitably end in disaster, Warburton warned; ‘the credit and capital markets have grown too rapidly, with too little accountability. Prepare for an explosion that will rock the western financial system to its foundations’. He called, among other things, for much tighter regulation of the derivatives markets and the removal of limited liability from speculative enterprises, to inhibit the reckless use of debt.

Warburton was far from alone in warning of the dangers of credit expansion. There was a small band of liberal journalists in Britain that registered the risks that the British and the Americans were taking and remained loyal to social democracy and common sense. Kay’s point about specific predictions has some merit but is somewhat beside the point.

The fire safety officer who tells you your house is a fire trap is trying to prevent a fire. If the place is still standing a week or a year after the warning it might still be a good idea to clear out the piles of paraffin soaked newspaper that block the exits.

As the credit bubble grew ever larger, and the danger it posed to the global economy grew ever more serious, the financiers, politicians and pundits spent many happy days hooting at the hapless officials who wanted them to take sensible precautions. Now they are trying to convince us that no one could have known that the house was in danger of burning down, and can they have their matches back?

The crisis was widely predicted by clear-headed and coherent experts. The people who could have averted disaster were too stupid, too venal or too wedded to the thrill of being in with the in-crowd to listen and take the necessary steps.

Don’t forget that.

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