Like a recurrent nightmare the collapse of yet another Wall Street institution is a reminder that the worst may not be over and perhaps other banks, in the US or somewhere else, are in line for a similar fate. Compared with when the sub-prime mortgage crisis erupted in the US in August 2007 the crisis has now moved from the financial and housing sector to the real economy, threatening jobs, consumption and investment - with the surge in commodity prices and inflation in early 2008 adding to the pain. And just as oil prices have fallen back, news of a sharply weaker Eurozone economy, rising US unemployment and further crises in the banks has turned hope to pessimism. How bad is it going to be?
We are now familiar with the chain of events which were sparked in a niche of the US mortgage market, spread out from the US markets in mortgage-related and other complex products and triggered a much broader 'credit crunch'. The current situation is one where credit problems, through various transmission channels, are also acting as a drag on global growth, causing the real economy to become itself a source of disruption - even reversing the causality chain. Nobody knows what to expect, but it is clear that the end of the tunnel is not in sight yet. Not surprisingly, then, all eyes are on central banks, regulators and supervisory authorities. The former are supposed to provide enough liquidity, and so to unblock the arteries of the banking system and reduce spill-overs to the real economy, while the latter should monitor the system to prevent similar crises in the future. Regulators, in their turn, are increasingly regarded as performing the critical tasks of setting the rules and 'guiding' the functioning of the market - and in the current market they even seem to be expected to prevent investors from taking hazardous decisions.
Because of the crisis's scope and intensity, all efforts have been concentrated on how to get out of the current mess while relatively little attention has been given to how to prevent future crises occurring. In particular there is little debate - especially in the current presidential campaign - on how the US has played and may continue to play the role of economic hegemon within the world economy. Its main contribution to global growth has come from consumption, with consumption increasingly more a function of indebtedness - fuelled by high house prices - than of disposable income. The result has been a large trade deficit and a household savings rate now at a record low. The crashing of the property market, the unsound growth of which fed the US consumption binge for almost a decade, has left American households loaded with unsustainable debt. This came as no surprise, though. As early as 2004 it had become clear where the imbalances were and where adjustments, soon or later, needed to come from.
So what to do next? Policy-makers seem to have run out of steam. All possible crisis-preventing measures have been applied to reduce the damage and avoid contagion to many different constituencies - from retail investors to tax payers. These measures stretch from emergency liquidity support to government-backed bailout of financial institutions. Such interventions rest on the widespread perception that the whole financial and banking system is too complex and integrated to fail. But this approach poses the question of to what extent a government is prepared to intervene to prevent a crisis which would wipe the savings and pensions of many individuals and families, and the signals this would send to markets. Any crisis-preventing intervention risks being perceived by markets as a 'macro bail-out', whatever the true intention and concerns of policy-makers may be, with the result that there may be excessive risk-taking, particularly when many systematically important and globally integrated institutions are in the same trade. A further complication in the current picture of integrated global financial markets is the 'globalisation' of risk.
Policy-makers now have to cope with the risks of turbulence in an environment that features universal financial intermediaries, widespread interstate and cross-border banking, complex instruments, and untransparently dispersed risks. Concerns about moral hazard and the resulting risk-taking are seen as being of little importance when the stability of the international financial system is at stake - and the alternative is a higher risk of systemic failure. Before the collapse of Lehman Brothers these measures had proved an effective way of keeping the situation under control and avoiding further deterioration in market conditions. They look less effective now and in any case it is too early to draw any firm conclusion. What seems clear, though, is that with governments having shown the ability and willingness to act as final rescuers, the case for moral hazard has become deeply rooted within the system. Whether this would make crisis prevention and crisis resolution even more difficult in future, it is, however, too soon to say.
Also read Down They Fall - Recessions Break Out as Banks Lurch into New Era by Vanessa Rossi, Senior Research Fellow on the International Economics Programme at Chatham House.