At its core, this rolling crisis is really about financial globalization. Both words are important. When I say globalization I do not mean primarily trade in goods and services, but rather the integration of previously national money markets and capital markets. Securities markets are increasingly global as pools of investable capital seek out the highest risk-adjusted return, on individual investments but also on diversified portfolios of investments from around the world. And money markets are also global, as national borrowers who seek more funds than domestic lenders are offering inevitably find what they need in global funding markets, especially dollar funding markets.
Financial globalization has created the modern world, and it is being tested to the core by the current crisis.
Previous smaller crises of financial globalization were typically triggered by funding problems in peripheral nations—think Mexico, or East Asia. Typically these involved a combination of currency crisis as well as banking crisis, because the lending was in dollars and the currency risk was backstopped in one way or another by the state. Just so, typically the agent of deliverance was some combination of the IMF and the United States.
To my mind, the LTCM crisis of 1998 was the first crisis of the emerging market-based credit system, but its relatively easy resolution left a misleading impression. LTCM was a hedge fund trading both long and short in global capital markets, and funding those trades in global money markets. The crisis was resolved by wiping out LTCM’s equity holders, and by forcing its other creditors to take equity positions. Meanwhile, the Fed intervened to maintain stability of the domestic dollar money market generally, which translated easily into stability of the world dollar money market.
In retrospect LTCM was just a warning shock, and today we are in the middle of the main event. Unlike LTCM, the current crisis has gone beyond private balance sheets and is taking the form of a fiscal crisis of the state, both in the US and in Europe.
In both the US and in Europe, central banks have been the key players, straddling as they do the line between private and public finance. In the US the trigger came from household mortgages while in Europe it is coming from sovereign debts, but in both instances the crisis quickly involved the central bank because a good chunk of the debt was funded short term, in the money markets. In both cases, when the crisis hit, the first approach taken by central banks involved intervention in the money market. In both cases, it wasn’t enough.
The problem was with the collateral, in both cases long term debt quite different from the kind of short term trade credit that was the focus of Bagehot’s classic 1873 analysis of central banking in times of crisis. Liquidity crisis showed itself not only in sudden demand for money but also in sharp falls of security prices, hence rising “haircuts” for the securities offered as collateral. The market for secured funding froze up because lenders of money did not want to risk getting stuck with illiquid security collateral.
Understanding this dynamic, both the Fed and the ECB responded by extending their traditional “lender of last resort” remit to include what I call “dealer of last resort”. They intervened not only in the money market but also in the capital market directly by buying particular classes of securities whenever their price fell too far below what the central bank considered to be fundamental value. Central banks became not only bankers’ banks, but also dealers’ dealers.
Both the Fed and the ECB were careful about what securities they bought. In the U.S. the Fed bought Mortgage Backed Securities, but household mortgages have a long history of special treatment (think Fannie and Freddie), so it could be argued that the Fed was simply building on that history, rather than deviating from its own history. In Europe, the ECB bought peripheral sovereign bonds, but again the whole European Union project involves special treatment for members, so again it could be argued that the ECB was simply building on that history rather that deviating from its own history.
From this point of view, it could possibly be argued that the extraordinary interventions of central banks can be justified as an extension of their accepted legitimate role as government bank. There is a case to be made.
But that case fails to explain why people are so upset. I think we have to take on board that central banks have been doing something dramatically new—using techniques of war finance to save private finance, and using techniques of national finance to save financial globalization—and try to understand what it means for the future.
Financial globalization has been the theme of world growth for the last three decades. Financial deglobalization could well be the theme of world contraction for the next decade. Those are the stakes.
Deleveraging is an enormous headwind, but behind that headwind is an enormous political economic problem: the shifting relationship between private finance and the nation state. Unless and until we confront that challenge, continuing contraction is inevitable.