Views differ on who is responsible for the crisis—reckless lenders, imprudent borrowers or lax regulators. What is undeniable is that it was facilitated by an innovation that is having an impact on many segments of the financial industry: the use of derivative products and “structured” securities. They are traded just like stocks or bonds and form the basis of what are more commonly known as exotic mortgages. Over the long term, such financial innovation is welfare-enhancing. It serves to reduce the cost of financial intermediation, to distribute risk widely and make markets work more efficiently. But like any such shift, the journey to this long-term destination is inevitably characterized by excesses and accidents.
It is not just that too many people are sucked into activities that are too new to be well understood and tested. It also takes time to retool market infrastructure, upgrade supervision and develop appropriate valuation and modeling techniques.
Not surprisingly, then, several financial markets are now feeling the type of liquidity dislocation that affected subprime. Indeed, at one stage a few days ago, activity in the market for corporate bonds almost came to a standstill. The risks of using these new types of financial devices are particularly potent if investors assume a high level of leverage. Just witness the recent demise of two Bear Stearns hedge funds.
Given all this, concerns about a U.S. recession and a subsequent derailment of the global economy are understandable. But they will prove warranted only if three major and distinct “circuit breakers” fail to operate in the months ahead:
The first circuit breaker is the significant amount of capital still waiting on the sidelines. The new sovereign-wealth funds of nations like China and other international investors currently have significant capital deployed in safe assets (such as U.S. Treasuries) with the stated intention of shifting to other, higher-yielding investments once market volatility subsides. Such reallocation would inject new liquidity into markets.
The second pertains to the unusually robust state of an international economy that is now driven less by the United States and more by emerging markets. This growth isn’t fleeting, but constitutes a “breakout phase” in the economic development of countries experiencing the highly stabilizing combination of significant employment creation, increasing financial wealth and tame inflation. The result is a more balanced global economy that helps moderate the impact of shocks originating in the overstretched segments of the United States.
The third circuit breaker speaks to the ability of policymakers, led by the U.S. Federal Reserve, to offset a credit crunch through aggressive reductions in interest rates. Few doubt the short-term effectiveness of such measures; earlier this decade, U.S. rates were aggressively cut in stages from 6 percent to 1 percent to successfully counter the combined influence of the tech crash, September 11, Enron, WorldCom and other corporate debacles.
Having said this, the Federal Reserve has to balance competing considerations. While such interventions stabilize markets in the short run, they involve longer-term “moral hazard” risks that can undermine the efficient working of a market economy. After all, the occasional occurrence of large and sudden losses plays a key role in sustaining market discipline.
This is not to say that a return of market stability is a sure thing. Circuit breakers could fail, and market dislocations could be aggravated by geopolitical shocks and protectionism. Indeed, these are risks that should be monitored and partially insured against through prudent portfolio diversification and targeted market hedges. But they do not constitute a major worry at this stage.
It is more probable that current market turbulence will gradually work itself out over the next 12 months, and do so without fundamentally contaminating economic activity around the globe. In the process, a degree of realism may be restored to markets where the combination of financial alchemy and hubris had led many to believe that asset prices only go up in value.
