the making of a financial crisis ...

Explaining the Global Financial Crisis

as per report..


The US homeowner loses a Faustian bargain

What are the roots of the global financial crisis, and why has it produced a sudden and shocking collapse in American confidence and economic activity?
What has really gone wrong is that that entire model has collapsed along with the global financial institutions that hot-housed it. Not only has the ceiling come down on the US household sector, but the wreckage is blocking the exits.
It is that collapse of any exit strategies that is doing the damage. Simply to retain household debt-to-equity ratios at last year’s levels will now take a contraction of around 6.1 percent in nominal private consumption spending next year. To eliminate that debt/equity ratio would need a contraction of around 25 percent - the Depression Option.
Since the problem is not the ‘normal’ Austrian one of over-capacity and deflation, the normal road to recovery – supply-side reforms and industrial consolidation to build assets and labor productivity – is unlikely by itself to be sufficient. Full-scale recovery will await the re-invention of a financial system capable of reawakening a much-abused appetite for risk.
1. First, and this is the only piece of quantifiable good news this article contains, this is not a classic ‘Austrian’ crisis of overinvestment and deflation. Or at least it fits into that model at a level of generalization so broad and long as to be analytically disappointing. Nowhere in the developed world have we seen the sort of reckless overinvestment which, for example, we saw in the 1997-1998 Asian financial crisis. Nominal capital stock is growing around 3.4 percent in the US, around 5.3 percent in Europe, and 2.3 percent in Japan – hardly the stuff of bubbles. Similarly, private sector savings deficits are not running out of control. Even in the US, the private sector savings deficit is likely to be only around 1 percent of gross domestic product this year.
These are not the sort of ratios which precipitate financial crises. We expect the balance sheet of the financial system to be a mirror image of the balance sheet of the rest of the economy. But if that were the case, the problem would not possibly have escalated so catastrophically so quickly. In fact the balance sheet of the financial system no longer principally mirrors the balance sheet of the rest of the economy. Indeed, such is the size and opacity of off-balance sheet contingent liabilities, that we can say the balance sheet of financial institutions no longer even mirrors the balance sheet of the financial system.
There was a motive for this: the expiration of the 27-year bull market. And there was the opportunity: the increasingly gothic financial structures of the derivatives market which, at a huge cost, created any yield curve you liked.
That divorce between real economy and financial system balance sheets really is a problem. It explains why, unlike any other financial crises I’ve witnessed or even read about, the problem is not that the US financial system has run out of money – the strength of the currency and government bond markets show that quite clearly. It’s simply that the institutions that can use that money either no longer exist, or can no longer be safely guaranteed to exist by the end of the financial and economic crisis.