Posted by: Dirk | September 24, 2008

The financial crisis – what happened?

Since I was on vacation in the last 2 weeks, I missed a big part of the action. Let me point to three noteworthy analysis that appeared in the meantime:

1) Anonymous at the WSJ (Sep 16th) writes:

The current panic is the ugly aftermath of the credit mania that took flight in the middle years of this decade. As students of economic historian Charles Kindleberger know (“Panics, Manias, and Crashes”), financial manias throughout history have shared one trait: the excessive expansion of credit. This bubble was no different.

The Federal Reserve kept interest rates too low for too long, creating a subsidy for debt and a global commodity price spike. The excess liquidity and capital flows this spurred became the fuel for the wizards on Wall Street and in mortgage-finance who created new financial instruments that in turn fueled the housing bubble. As long as it lasted, nearly everyone inhaled the euphoria of rising asset prices and soaring profits. Normal risk assessment gave way to the excesses that always attend manias.

2. Nouriel Roubini at the FT (Sep 21st):

Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self­fulfilling and destructive run on its ­liquid liabilities.

3. Paul Krugman at the NYT (Sep 19th):

Some people have been making that argument for some time. Most recently, Paul Volcker, the former Fed chairman, and two other veterans of past financial crises published an op-ed in The Wall Street Journal declaring that the only way to avoid “the mother of all credit contractions” is to create a new government agency to “buy up the troubled paper” — that is, to have taxpayers take over the bad assets created by the bursting of the housing and credit bubbles. Coming from Mr. Volcker, that proposal has serious credibility.

This is where we are now: debating the Volcker proposal to nationalize the toxic waste (this is what Sweden did during its financial crisis in the 90s, see this paper by Peter Englund). Some $800bn are needed to finance this. Where should the money come from? Three possibilities arise: 1) selling t-bonds, 2) printing money and 3) using tax money. They boil down to two if one is clear about who finances the proposed agency, either through the sale of t-bonds or taxation: US citizens or foreigners abroad. In the first case, aggregate demand will suffer. If the money is taxed away, consumption will decline and make matters worse in the real economy. In the second case, the dollar will suffer, since the debt has increased (and must be paid back sometime). This might lead to a dollar flight, which means that foreigners abroad sell dollar-denominated assets. It would probably make everything worse on the financial side: selling causes asset prices to fall, which triggers more selling by actors who are forced to pay off their own debt. Still, one of the two possibilities must be chosen.

UPDATE 25/09/2008: I was not aware that the $800bn (or $700bn) plan is somewhat different from what I thought. Paul Krugman makes the point here.


  1. This crisis is a lesson showing us how interconnected all the worlds finances are. Any action the government takes to help ease the financial crisis will only treat the symptoms, not the cause. Until we treat the cause we will see one world crisis after another.
    Mans EGO has brought us here and the only changes that will help are the ones we make ourselves. The following link describes what action we need to take to remedy the situation.

  2. I read today in the NYT about Volcker being marginalized in the Obama WH in respect to his advise on how to obviate another financial crisis. I wrote a post on it arguing that the nation’s financial houses are apparently able to squeeze out even a credible voice that is no longer in their financial interest. I am much less surprised to find this going on, than that Barak Obama and those he has selected as his advisers are represented here as being on the side of the financial culprits. A case of cooptation, I believe. I’m assuming that Barak wants a second term pretty bad and is willing to… (you know)

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