Today’s crisis is the West’s first taste of a new generation of financial crisis, already known to the developing world from its 1997-98 crises.
De-leveraging is the liquidation of exuberance. When fundamentals have long since belied the optimistic notions underlying exuberance, debt contraction is in store. To be sure, East Asia’s economy by 1997 had already departed significantly from the premise of the Asian Miracle. A link to the supercharged US dollar left output increasingly less competitive internationally, with overvaluation evident not only in the booming non-traded sector but yawning current account deficits. Stock markets began signalling the crisis months before the actual financial crisis unfolded, beginning with the Thai baht devaluation of June 1997.
What made this a new generation of crisis was the form of capital caught up in the souring assets. It was securitised. This made the crisis all the more difficult to manage. You could not renegotiate a loan with a thousand or more creditors. Furthermore, knowing this, the creditors themselves had no incentive other than dump the debt and flee the currency. This was a collective action problem of the first order. The Asian Crisis is typically called a ‘new generation’ of crisis insofar as it is a ‘capital account crisis’; part-in-parcel of this distinction is the securitised nature of capital.1/
This is a key distinction between today’s crisis and the US savings and loan crisis of the late 1980s. That episode’s souring assets belonged to banks; they could be assumed by the government and sold at auction. The souring assets of today’s crisis belong to the market – and that exposure is not limited to a single insurer, a single money manager, or a single foreign financial institution. It runs the gamut from US pension funds to European retail banks. We are beginning to see the actualisation of previously vaguely exposited worries over ‘systemic risk’ in the securitisation of financial capitalism.
The realisation of systemic risk is not the actual dispersal of losses in the body capital. It is the seeds of doubt sewn in the corpus. It is simply not knowing where exposure to cavalier credit is hiding. ‘Systemic risk’ is the financial system’s loss of confidence in itself. We now see the error in Alan Greenspan’s contention that securitisation would soften the blow of asset spoilage, by spreading the pain so widely. Instead, diffuse exposure to failing assets has destroyed faith – which is the meaning of credit in its original Latin, credere, “to believe”.
Which is why TARP might have limited effect. The 700 billion dollar purse is less than half of the two trillion in “nonconforming” mortagage debt created during the bubble. Not all of this will sour, but enough will remain dispersed to undermine confidence. The key issue is doubt about the credit worth of your counterparty. Note that it is not only the credit worth of your counterparty that you must consider, but also the credit worth of their counterparties. The pernicious nature of this systemic loss of confidence is becoming increasingly easy to grasp.
There is a parallel in the East Asian crisis. Why did that crisis spread so quickly from that initial Thai devaluation, to one enveloping more than a half-dozen of the world’s premiere emerging markets? It was due to a similar loss of faith. Capital markets were not irrational to exit a swathe of seemingly only superficially similar country portfolios. The Thai devaluation was a wake-up call. Quite prudently, investors looked around the fundamentals and did not like what they saw. The fall of Bear Stearns today had much the same effect. Markets correctly questioned the worth of banks which once seemed unassailable. (Lehman’s collapse went a step further: telling markets not only to question banks’ balance sheets but the depth of government resolve to support them.)
How did the 1997-98 crises play out? 2/ Through complete loss of faith in those economies’ assets, not least their currencies. Lower exchange rates left no choice but to base recovery on a starvation of imports and a stimulus to exports. This is why talk about reforming America’s capital markets is so premature. The US economy will not have the luxury of regulating a boom in credit anytime soon. It will have to work its way out of this hole through export surpluses, and the impoverishment of adverse terms of trade that come with them.
Supporting the post-98 rebound in Asian economies was a vibrant West. Fortuitously, Asia’s economies, along with much of the developing world, are in a strong enough position today actually to offset some of the weakness in America’s economy, and indeed to pull it up through the force of imports. But a caveat looms. If the Asia-grows / America-heals story is to work, Europe must play at least a neutral role. That will not be possible if the European economy softens considerably. And it will certainly not be possible if the single European currency fails. A plunging American currency obviously requires a strong European one. If the euro fails, weak US and European currencies will compete each other to the bottom. It will be beggar-thy-neighbour all over again. To which topic I’ll return in a subsequent post.
1/ A notable exception was cross-border banking exposure to South Korean conglomerates. But this proved the rule: because these credits were centralised, US authorities were able to lean on their originators and instruct them to roll-over maturing loans.
2/ The US economy is obviously different from these not only because it is a paid-up member of the OECD but most important because it issues the world’s preferred currency of invoice and intervention. Thus the crux of the current debacle lies in the longevity of this privilege — America’s exorbitant privilege, as De Gaulle put it.