The real problem is that risk has been unbundled and passed around to such an extent that the market - and probably not central banks, either - doesn't know who's got the good stuff, or indeed what good stuff looks like any more.
Puzzled by the current gyrations of the world’s financial markets? This time you’re right to be. You’re also in good company, as no one seems to know what the hell is going on. And that’s part of the problem. If any of the following makes any sense then it’s probably wrong.
To explain why, think back to the sunny, carefree days a few weeks ago. On August 7, 2007, the Federal Reserve held its monthly meeting to set interest rates.
It didn’t make any changes, but it did note that while the financial markets “have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing,” otherwise everything was fine.
In fact, it was more worried about strong demand, and suggested that “the committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.” Ah ha. Notice what that statement didn’t say.
It didn’t say, “There’s a good chance that in a few days’ time the Fed and the European Central Bank will be shovelling money at the financial markets as fast as we can get it out the door” to keep the financial system functioning. Fed lent $ 38 billion in a single day and also cut interest rates. On top of that it put out a statement that the next most move is its key interest rates going downwards.
Casual approach
It would appear that the central banks think the recent events - the 10 per cent fall in the stock market, private lenders refusing to lend on a range of suddenly unwanted financial instruments, the dumping of riskier assets, the rush to buy government bonds as a safe haven - are mainly financial market events, and that by calming the gyrations things can be worked out in orderly fashion.
It would take too long to explain what the chaos is all about, and probably be wrong. The real problem is that risk has been unbundled and passed around to such an extent that the market - and probably not central banks, either - doesn’t know who’s got the good stuff, or indeed what good stuff looks like any more.
That is hardly surprising since recent hedge fund risk management seems to have become “sell it to someone else” - an updated version of an ancient tactic known as the “greater fool” school of investment. Instead of risk, which markets can deal with, we now have uncertainty - and that’s just a big black hole that all the whiz-kid PhDs in the world can’t see through.
So the central banks hope to buy time and let the dust settle. Then it can see what the real effect on the economy has been. The Fed got off to a flyer by making its interest rate-cutting splash as the markets opened, and turning around a week-long equity rout. But it didn’t last long and the rally was not gathering steam as the S&P 500 stock index remained weak.
Too many bubbles
So will shouting “Don’t panic!” do the trick? It usually doesn’t - my first thought when the Fed cut rates was that things were far worse than anyone had realised. For all the talk about dodgy mortgage lending, the market turbulence is a symptom, not cause.
What we have had in the US is the collapse of a housing bubble (one that was more like traditional British housing bubble, a novelty for Americans) followed by a stock market bubble, fuelled by cheap interest rates over a long term and a stimulative government budget deficit.
It was little more than a month ago that the Dow Jones industrial average went over the 14,000 mark, a record high, amid celebration.
Well, it was a bubble, the bubble burst as they are wont to do - and it did so after the Fed and other central banks kept raising interest rates to something approaching “normal” levels for the first time since the 1997 Asian crisis, rising alongside commodity prices.
More bad news?
What happens next? Well it seems most likely, to me, that the stock market slide will resume and that the credit crunch won’t go away soon. The Fed will soon have to cut its main interest rate.
There will probably be a few hedge funds taken out and shot, to encourage the others. But nothing will happen, since not only is the cat out of the bag but the bag has been sliced up and sold off and the cat been securitised into a mouse delivery unit. Should the regulators get tough? Probably not - modern central bankers, almost always decide to bail out the financial markets in the short and medium term, otherwise known as the Alan Greenspan method.
To do so may just be storing up trouble, but we won’t know that for a while. There is always the small chance of a day of reckoning. But the notion isn’t very useful. Someone from a hedge fund will gladly sell you a contract against the chances of it ever happening.
