Who should apologise for the credit crunch?

Feelings about the financial crisis are currently running very high. Understandably, people and their representatives are asking why it was not foreseen, and demanding to know who is to blame.

It was hard for economists to predict this simply because nothing like this has ever happened before. History is littered with financial crises, but the collapse of the market in liquidity that lies at the heart of this problem is almost without precedent — the collapse in international trade finance that took place after the assassination of the Archduke Ferdinand in Sarajevo, in the run up to the First World War, apart.

To find out who was to blame requires an analysis of the roots of the crisis. These lie in the global imbalances that have been building up for decades and making the world economy increasingly vulnerable. Huge savings in Asia depressed world interest and inflation rates, and were channelled through US banking system to western borrowers, this being reinforced since the millennium by the flow of petrodollars. But it would be wrong to blame individual Asian savers or western borrowers, who were simply responding to the economic environment they found themselves in.

That helped drive the boom in UK mortgage and housing markets and the fall in the saving ratio. In 2006 our mortgage lenders were handing out £10bn of mortgages every month — and only getting in £5bn of that from savers. The rest was coming in from overseas banks. This built up to an overseas debt of £740bn between 2000 and 2006 — worth over half of our GDP — typically with a very short maturity. These dollar inflows had to be converted into sterling, which is why the exchange rate was so strong and exports so weak.

The bankers cannot escape the blame so easily. It’s clear with hindsight that the business models of institutions like Northern Rock and HBOS that relied heavily on wholesale markets were flawed. How could the FSA allow them to do that? But bear in mind that lenders like Paragon that relied 100 per cent on this type of funding have (just about) survived. Actually, it was the combination of wholesale funding and run-prone instant access savings deposits that brought the Rock down. That raises questions about the Treasury’s inadequate deposit insurance scheme and the reluctance of the governor of the Bank of England to support liquidity by lending at market rates like Bernanke and Trichet did when the markets froze in August 2007. That forced the Rock to borrow at the Bank’s penalty rate. That in turn allowed Robert Peston to describe this as ‘emergency’ funding, raising questions about the media’s role. The list of people involved in (or at least at the scene of) this particular accident is endless.

What about macroeconomic policy? Are the economists to blame? Should the prime minister apologise?

We all knew this expansion could not last. It cannot be described as a ‘boom’ simply because growth was close to the trend (of 2¾ per cent or so), and inflation was under control until last year. But it was clearly unbalanced and as such unsustainable. It didn’t matter whether you looked at the global imbalances, the level of house prices or the 125 per cent mortgages that lenders were blithely handing out, this clearly could not last.

People had been predicting a sticky end for years, but the dance just went on and on. Gordon Brown was repeatedly warned of the risk we were running with high levels of borrowing by the OECD, the IMF and other institutions. However, the music was so loud he could not hear. He was not the only one. The Bank for International Settlements clearly warned of the threat to the global financial system posed by financial engineering and high levels of leverage. However, the markets refused to listen and just carried on dancing.

The problem was that when it finally came, the end of the credit boom was much more sudden than anyone imagined. Most economists, including me, thought in terms of a gradual rebalancing as the build up of debt and increasingly unaffordable house prices applied the brakes. We usually expect things to turn round gradually, moving in a cyclical way rather than screeching to a halt. However, this time the international banking markets simply froze like a rabbit in the headlights, abruptly halting the inflows into sterling and the credit markets.

Financial markets can turn on a sixpence, but they usually remain open for business, even after a stock market crash. As Hyman Minsky observed, credit markets swing from elation and speculation to panic and contraction, but they have not shut down before, at least in peacetime.

Interest rates and financial prices can react violently in a crisis, but usually they manage to get demand back into line with supply. If confidence collapses it may take a big fall in the stock market to tempt bargain hunters back in, but eventually this happens.

Credit markets seem easier to understand than the stock market but are actually much more complex. The basic problem is that a bank lends on a small margin and never gets back more than principal and interest. However it can lose the whole of its principal. That’s not a problem if the asset markets and the economy are moving in an upward direction, but it leaves banks heavily exposed in a downturn. That is why they always cut back on lending in a recession — remember the anger about bank behaviour in the recession of the early 1990s. Bank finance always has the effect of amplifying the economic cycle.

It is now clear that the Basel II form of regulation provided further amplification. Basically the amount of capital the banks’ shareholders have to put up goes down in the expansion phase because the mathematical models that are used to assess the risk say that this is low, with the opposite happening in a recession.

Banks will often ration their customers in a recession. If the supply of bank finance is cut, interest rates will normally rise to help bring demand into line with supply. But as Joseph Stiglitz pointed out in a famous paper with Andrew Weiss in 1981, this will discourage prudent borrowers who tend to be price-sensitive, increasing the proportion of bad risks on the loan book. It is hard to prevent this: bank managers can’t really distinguish the bad risks, otherwise the customers would not get a loan in the first place. Credit risk rises, particularly if a recession results, meaning that a rise in the loan rate can actually reduce the profitability of the loan book.

As I say, in this situation, banks tend to ration their customers rather than raising rates any further. But something more serious happened in August 2007: this effect shut down the inter-bank and other wholesale credit markets. Inter-bank rates naturally moved up as the market began to worry about bank losses on sub-prime loans, but they reached a point at which they began to raise questions about the borrower’s ability to repay. Any bank that was prepared to pay one per cent or so over the odds clearly had a liquidity problem. It might also have a solvency problem, especially if it was relying on high-cost wholesale funds to fund a historic portfolio of low-cost mortgages. So any banks that did have surplus cash simply hoarded it rather than risking it.

Of course there was more to it than that. Once the Northern Rock failed, it became clear that wholesale depositors could not rely on the bank regulators to monitor the banks properly. This also raised doubts about the Bank of England’s ability to help out banks without stigmatising them, even if they just had a temporary problem with their liquidity. Moreover, when the credit markets dried up it was no longer possible to place a market value on many of the banks assets. But whatever the reasons for this, the banks simply stopped lending to each other. Then they stopped lending to us.

So who is to blame? In a sense, no-one and everyone. Right now it’s much more important to find ways of extricating ourselves from this situation. Those apologies will have to wait until later.