Monday, September 03, 2007

Market Power

As the forecast credit crunch continues, it is interesting to note the themes coming out of the Jackson Hole Fed conclave. While Central bankers like Axel Weber of the Bundesbank spoke of the reaction of the markets being "a classic bank run"- in fact the fear persists that under the crisis of liquidity there is a more fundamental real economic crisis. As my friend David Hale notes, there is in fact a "crisis of information"- and in uncertain times, the fear is becoming all too real and filling the information gap with horrible imaginings.

After the Great Crash of 1929, I believe that it was Alistair Cooke who first observed that the Everest in the markets achieved in 1929 was "a mountain of credit resting upon a molehill of actual money". Unfortunately, the asset bubble in US sub-prime mortgages rested upon an income stream that was too small to sustain the inflated valuations. Ultimately it became a giant game of pass the parcel- and the meltdown has undermined the security of global credit across the board.

Over the twentieth century, and particularly after the financial crises of the 1920s and 1930s, the system of central banks has managed to protect a credit system based upon banks. Reserve requirements, depositor insurance and the regulatory framework have been set to protect depositors, and the wider financial system, from major losses as the result of a loss of confidence. Just as important, the SEC was set up to police the excesses of the market place. After all, as Dr Henry Kissinger remarked, "The most powerful source of discipline we have around the world," he said, "is the power of the markets".

Even still, as the Chairman of the Swiss Central Bank, Jean-Pierre Roth remarked, with something close to disbelief in his tone: "People [in the US] who had neither income nor capital got credit with very attractive conditions that could only be tightened with time". Roth underlined that the situation was encouraged throughout the US economic system from financial institutions that set up structured products covering such lending, to ratings agencies that gave their seal of approval. "And now we are seeing that there isn't a market for such papers. Now reality is striking back. That leads to massive losses and there will be victims".

In other words, there may be something close to an old fashioned "run" on the financial system, but that does not mean it is not justified. Until the Markets know the full scale of the problems, they will be inclined to fear the worst.

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