KEY POINTS:
As we watch the bailing-out of failed financial institutions with taxpayers' money on both sides of the Atlantic, we find that, finally, it is socialism in our time; but it is socialism for irresponsible (sorry, they are also responsible) bankers to safeguard the wider public weal.
People keep asking me about the historical parallels. They may be parallels, or tangents. Parabolas even. The South Sea Bubble, Dutch Tulip Mania, the events leading to the Wall Street crash of 1929 and the economic impact of the oil crises of the 1970s all come to mind.
It was indicative that, having presided over a period of low interest rates that didn't dent "irrational exuberance", the former chairman of the US Federal Reserve, Alan Greenspan, turned his focus, in his memoirs, to those two primal human motivations: greed and fear.
Greed was the driving force behind the recent worship of the financial sector; and fear, as Greenspan recognised - he who thought complicated "derivative" financial instruments were the economic philosopher's stone, gaily spreading and eliminating risk - has taken over. Above all, trust, the cornerstone of good banking and financial practice, has been eroded.
One striking aspect of the credit crunch is the revelation that "they" didn't know what they were doing either. By "they" I mean the financial whizz-kids who spoke in a jargon few intelligent laypeople understood - a lack of understanding often shared by their bosses.
DERIVATIVES
I am struck by the frequency with which bankers and lawyers stress the complexity of so many of these "derivative contracts" that are now unravelling.
Derivatives are financial assets whose value depends on the value of one or more other assets. They enable traders to hedge their bets on the movement of interest rates or exchange rates - to hedge or to gamble.
As John Eatwell and Lance Taylor wrote in Global Finance at Risk (2000), after the collapse of the Long Term Capital Management hedge fund in 1998, "one use of derivatives has been to create 'towers of leverage' far taller than those that helped bring down the American financial system in the 1920s".
LEVERAGE
Private equity groups such as Blackstone and Carlyle were conducting huge deals on the basis of an inverted pyramid. In "leveraged" deals, the base of the pyramid is your own money; the rest is borrowed. When the loans are called in, there is a domino effect.
The parallels with the "something for nothing" mania of earlier historical episodes are uncanny. As John Kenneth Galbraith wrote in The Great Crash: 1929, "Had these securities all been sold on the market, the proceeds would invariably have been less than the current value of the outstanding securities of the investment company."
HERD BEHAVIOUR
This is common to most historical financial crashes. As Professor Charles Goodhart said in his recent GLS Shackle Memorial Lecture at St Edmund's College, Cambridge (topically entitled "Risk, Uncertainty and Financial Stability"): "Since we are a social animal the tendency will be for us to think and decide much as everyone else. But if we, and everyone else, are taking similar decisions, and perhaps at the same juncture, that can lead to large jumps, discontinuities in outcomes. All ... very evident recently in financial markets."
Parallels with 1929-32 should not be overdone, because, as can be seen from recent Federal Reserve monetary actions and from the speed with which the US Treasury moved to aid the rescue of the investment bank Bear Stearns, policymakers have at least learnt over the years that conditions should be loosened, not tightened, at such times.
STAGFLATION
The parallel with the 1970s is the collapse of the US dollar, the high price of oil and the fear of "stagflation", which occurs when inflation accompanies stagnation. Ben Bernanke, chairman of the Federal Reserve, is well schooled in the horrors of the Great Depression and the Japanese deflation of the 1990s. His fear is most certainly that of deflation.
By contrast, his colleague on the Fed open market committee, Richard Fisher, president of the Reserve Bank of Dallas, recently said that he feared too much monetary easing at this stage might provoke a revival of inflation.
Personally, I think deflation rather than inflation is the danger. But I am reminded that the high interest rates of the early 1980s contributed to the Mexican debt crisis of 1982. Asked why he continued to lend to Mexico when he could see the crisis coming, the Mexico expert at a leading bank replied: "Because it was my job."
- OBSERVER
