The worst market crisis in 60 years

The current financial crisis was precipitated by abubble in the US housing market. In some ways itresembles other crises that have occurred since the endof the second world war at intervals ranging from fourto 10 years.However, there is a profound difference: the currentcrisis marks the end of an era of credit expansion basedon the dollar as the international reserve currency. Theperiodic crises were part of a larger boom-bust process.The current crisis is the culmination of a super-boomthat has lasted for more than 60 years.Boom-bust processes usually revolve around credit andalways involve a bias or misconception. This is usuallya failure to recognise a reflexive, circular connectionbetween the willingness to lend and the value of thecollateral. Ease of credit generates demand that pushesup the value of property, which in turn increases theamount of credit available. A bubble starts when peoplebuy houses in the expectation that they can refinancetheir mortgages at a profit. The recent US housing boomis a case in point. The 60-year super-boom is a morecomplicated case.Every time the credit expansion ran into trouble thefinancial authorities intervened, injecting liquidityand finding other ways to stimulate the economy. Thatcreated a system of asymmetric incentives also known asmoral hazard, which encouraged ever greater creditexpansion. The system was so successful that people cameto believe in what former US president Ronald Reagancalled the magic of the marketplace and I call marketfundamentalism. Fundamentalists believe that marketstend towards equilibrium and the common interest is bestserved by allowing participants to pursue their self-interest. It is an obvious misconception, because it wasthe intervention of the authorities that preventedfinancial markets from breaking down, not the marketsthemselves. Nevertheless, market fundamentalism emergedas the dominant ideology in the 1980s, when financialmarkets started to become globalised and the US startedto run a current account deficit.Globalisation allowed the US to suck up the savings ofthe rest of the world and consume more than it produced.The US current account deficit reached 6.2 per cent ofgross national product in 2006. The financial marketsencouraged consumers to borrow by introducing ever moresophisticated instruments and more generous terms. Theauthorities aided and abetted the process by interveningwhenever the global financial system was at risk. Since1980, regulations have been progressively relaxed untilthey have practically disappeared.The super-boom got out of hand when the new productsbecame so complicated that the authorities could nolonger calculate the risks and started relying on therisk management methods of the banks themselves.Similarly, the rating agencies relied on the informationprovided by the originators of synthetic products. Itwas a shocking abdication of responsibility.Everything that could go wrong did. What started withsubprime mortgages spread to all collateralised debtobligations, endangered municipal and mortgage insuranceand reinsurance companies and threatened to unravel themulti-trillion-dollar credit default swap market.Investment banks' commitments to leveraged buyoutsbecame liabilities. Market-neutral hedge funds turnedout not to be market-neutral and had to be unwound. Theasset-backed commercial paper market came to astandstill and the special investment vehicles set up bybanks to get mortgages off their balance sheets could nolonger get outside financing. The final blow came wheninterbank lending, which is at the heart of thefinancial system, was disrupted because banks had tohusband their resources and could not trust theircounterparties. The central banks had to inject anunprecedented amount of money and extend credit on anunprecedented range of securities to a broader range ofinstitutions than ever before. That made the crisis moresevere than any since the second world war.Credit expansion must now be followed by a period ofcontraction, because some of the new credit instrumentsand practices are unsound and unsustainable. The abilityof the financial authorities to stimulate the economy isconstrained by the unwillingness of the rest of theworld to accumulate additional dollar reserves. Untilrecently, investors were hoping that the US FederalReserve would do whatever it takes to avoid a recession,because that is what it did on previous occasions. Nowthey will have to realise that the Fed may no longer bein a position to do so. With oil, food and othercommodities firm, and the renminbi appreciating somewhatfaster, the Fed also has to worry about inflation. Iffederal funds were lowered beyond a certain point, thedollar would come under renewed pressure and long-termbonds would actually go up in yield. Where that pointis, is impossible to determine. When it is reached, theability of the Fed to stimulate the economy comes to anend.Although a recession in the developed world is now moreor less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend.So, the current financial crisis is less likely to causea global recession than a radical realignment of theglobal economy, with a relative decline of the US andthe rise of China and other countries in the developingworld.The danger is that the resulting political tensions,including US protectionism, may disrupt the globaleconomy and plunge the world into recession or worse.

George Soros