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changing nature of the global financial system « Previous | |Next »
September 17, 2008

Paul Krugman in The New York Times makes a good point about the way the global financial system has changed. In doing so he pinpoints how the regulatory regime of the US financial system has failed.

PennI.jpg Ingam Pinn

Krugman says:

To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the “shadow banking system.” Depository banks, the guys in the marble buildings, now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by “nondepository” institutions, institutions like the late lamented Bear Stearns — and Lehman.

What evolved was the brave new US financial system----what Krugman calls the “shadow banking system” and it is this which is melting away before our eyes.

Krugman adds:

The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn’t so much reduced as hidden: all too many investors had no idea how exposed they were.

He adds that the defenses set up to prevent a return of those bank runs, mainly deposit insurance and access to credit lines with the Federal Reserve, only protect the guys in the marble buildings, who aren’t at the heart of the current crisis.

Yesterday, Peter Costello in his National Press Club address rightly raised the issue of regulation pointing out that the US has bad regulation and Australia has good regulation. Bad regulation of the US sub prime mortgage market was the cause of the problem, and Australia's good regulation was due to his time in Treasury. Costello, in making this point, was referring to the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term client, not the “nondepository” institutions-- like Bear Stearns and Lehman-- or the shadow banking system institutions. However, as Krugman points out the guys in the marble buildings aren't at the heart of the crisis.

Krugman concurs about the lack of regulation in the US as the cause of the problem --- but he is referring to the shadow banking system institutions:

The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system — if institutions need to be rescued like banks, they should be regulated like banks — why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for “orderly liquidation” of failing investment banks. Well, that was six months ago. Where’s the mechanism?

Costello knows this. At the National Press Club he was talking up the Australian financial system and selling or big noting himself vis-a-vis the Rudd Government. To his credit Costello did highlight the significance of the global financial system to a Canberra Press Gallery that was obsessed with Liberal leadership, and which has little understanding that this will turn out to be the worst financial crisis since the Great Depression and the worst US recession in decades. Presumably this is just too large for the Canberra Gallery hacks to cope with. It wasn't denial on their faces, it was incomprehension.

What Costello didn't say----and he should have since he talking truth to power-- was that the ability of US policy authorities to prop financial markets is rapidly eroding as market participants perceive that policy makers are desperate and running out of options. He did say that the US was a now debtor nation not a creditor.What he didn't say was that the US government cannot afford to provide the subsidy as the moral hazard problems are becoming severe. and that the real danger is the run on most of the shadow banking system, especially the other major independent broker dealers Morgan Stanley, Goldman Sachs now that Lehman and Merrill Lynch have gone down the tube.

| Posted by Gary Sauer-Thompson at 8:45 AM | | Comments (7)


The fallout in Australia can be seen with Babcock and Brown.Shares of Babcock & Brown 35% to $1.03 in afternoon trading, cutting the firm's market value to $357 million. The stock has tumbled 96% this year.

The effect of global credit markets seizing up is that they are cutting off access to cheap loans to finance acquisitions of ports, power stations and airports, which Babcock bundles into funds it manages.

Investors and banks are now shunning highly leveraged companies.

Why the surprise Gary. The Canberra Press gallery are economic illiterates. They have become hacks with a tabloid mentality who are immersed in the 24hr political news cycle. They'll gossip about the Liberal leadership for days going over every nuance again and again whilst ignoring what is happening behind their backs in the global financial system.

Costello should speak out more on this. He has the credibility and the freedom to do so with his political memoirs.

the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.

Have you read Hyman Minsky’s book Stabilizing an Unstable Economy? Minsky argues that a long period of rapid growth, low inflation, low interest rates and macroeconomic stability bred complacency and increased willingness to take risk. Stability led to instability. Innovation – securitisation, off-balance-sheet financing and the rest – has, as always, proved a big part of the story. As Minsky warned, undue faith in unregulated markets proved a snare.

Even the Wall Street Journal has taken note of Minsky:

Indeed, the Minsky moment has become a fashionable catch phrase on Wall Street. It refers to the time when over-indebted investors are forced to sell even their solid investments to make good on their loans, sparking sharp declines in financial markets and demand for cash that can force central bankers to lend a hand.

Central bankers forced to lend a hand indicates market failure.

Good cartoon to illustrate the issue. Very strong in its stark and descriptive imagery.

How ironic that it will fall to the administration of an Afro-American to clean up the mess. Then again it may have been a woman, or the woman on stand by (and where that would go, who knows).

It would be interesting to know in the circumstances, and maybe voters will insist it necessary, who the next Secretary of the Treasury will be.

this major failure of market capitalism kinda knocks a hole in the argument that a successful economy can founded on services: tourism and suchlike; intellectual property; and financial expertise.

It's amazing. The die hard free marketeers have turned to the nationalisation of Freddie Mac and Fannie Mae and AIG. Nationalisation was taboo for Wall Street and Republican Washington. The reach and power of the state has been greatly extended. The Bear Stearns bail-out involved the Fed moving to cover investment banks. With the AIG takeover, it has moved into insurance. So much for the small state celebrated by the free marketeers.

Roger Altman in an op-ed in the Financial Times--- Modern history’s greatest regulatory failure is directly on the point of the failure of regulation in the US. He says the key question now is: how much worse can this get?

He answers by saying that the lack of confidence is self-fulfilling and endangers other financial institutions. These are companies that re­finance themselves in the capital markets every day. They depend on the confidence of lenders. But, if that disappears, their solvency is threatened. This is where we are now. He then looks at the regulatory issue:

This has put the Fed and the US Treasury into a nearly impossible position. At one level, the Fed’s core mission is to protect the stability of our financial system. It engineered the rescue of Bear Stearns and extended emergency credit to Fannie Mae and Freddie Mac because it judged that the systems might not withstand their collapse. It has legal authority to provide unlimited assistance to others

But there is a practical limit to further bail-outs...Yet it is extremely difficult for the authorities to judge which blows the system can endure and which might trigger a meltdown. There were no precedents for judging whether the biggest insurance company could be allowed to fail or whether a domino effect would follow. Ultimately, the Fed saw too much systemic risk, reversed course and intervened in AIG.Whether the Fed and Treasury can continue to make these excruciating case-by-case judgments is unknowable. If forced to choose between staying within prudent limits on its assistance, or saving the financial system, it must choose the latter.

He adds that this crisis will come to be seen as the greatest regulatory failure in modern histor, adding that:
The degree of leverage that these institutions took on is indefensible. The average large securities firm was leveraged 27 to one in mid-2007. They were not regulated by any prudential supervisor. In effect, they regulated themselves. The lack of transparency was stunning. Many big lenders did not disclose off-balance-sheet risks. In some cases, they did not understand these risks themselves. More fundamentally, we allowed a second, huge financial system to develop outside the normal banking network. It consisted of investment banks, mortgage finance companies and the like. It was unregulated, not transparent and way too leveraged. But with nine separate and mostly ineffective financial regulators, these risks were ignored. That is, until this second system crashed.

It could have been prevented with proper regulation.