What’s really happening in the economy?

I have here tried to explain – to myself as well as to anyone else who cares to read it – what has been going on in the ‘credit crunch’. If anyone disagrees with what I’ve written here, I’d be glad to have a correction.

I’m not a financier or an economist. Bankers and financial traders may of course have a different viewpoint but one should try to understand why they take the position they do.

So, starting from the beginning:

To a bank, a debt owed to the bank is an asset. It is something that can be traded. For example, the bank could sell it to another bank. The other bank knows that the debtor could possibly default on the loan, and so will pay less than the actual value of the loan, to take account of the risk of default.

Risk is a part of doing business, whether buying and selling or doing business. In the physical world you may be able to reduce your risk by changing things (reduce your speed, buy a safer car, move out of an earthquake zone and so on). There is no way to reduce risk financially, apart from abstaining from an investment.

In finance, you can only share the risk with other people, who will expect something in return. Most of us know that insurance companies will shoulder some of the risks on our homes, cars, health and vacations for a fee. In turn, the insurance companies reinsure their risks with other companies, so your risk is shared around.

In business there are risks like defaults on debts (including mortgages), finding your raw materials have risen in price when you take delivery of them, and changes in exchange rates if you import or export.

Contracts to reduce risk have been around for centuries. A simple one is a future, by which you agree to sell or buy some commodity at some time in the future at a fixed price. If you’re buying, you may lose out if the price has gone down but if the price has gone up you have been able to budget knowing you would not have a nasty surprise.

There were two major developments in the twentieth century. Exchanges developed where businesses could trade these contracts, known as ‘securities’. Basically, these are a good thing, because they enable capital to be more easily accessible. If you hold a security and you need your money, you can sell it for the best price you can get.

At the same time, more and more mathematically qualified people (who call themselves ‘quants’) moved into the field and created new kinds of securities that took the basic kinds of debt obligation and combined them using complex formulas. These complex securities, called ‘derivatives’, have become increasingly hard for the non-mathematical to understand, and it may be no longer clear what risks are actually being carried by a given derivative.

When it’s traded, a derivative is a promise by an institution (likely a well-known and respected bank) to pay a certain amount of money at a given time (or times) or on the occurrence of a certain event (which may depend on a complex calculation). What the trader does not know – and does not need to know – is that wrapped up somewhere in that derivative is a portion of the debt of the owner of 911 Nowhere Drive, Wasteland, Arizona, who has just been made redundant and can’t afford the repayments any more. And portions of the debts of a lot of people like him.

But the derivative has a value, and as an asset it can be used as security to raise another loan. This debt, in turn, can be ‘securitised’ into other derivatives. And so on, indefinitely.

Remember that the risk is not being reduced. It’s simply being redistributed through a sequence of packages. There are only a limited number of banks and other institutions participating in this market in the world. So they are sharing the risk around but in away that they no longer know exactly what risk they are bearing. But somewhere at the bottom of this pyramid of debts are our mortgages and loans and the loans that businesses take out in order to provide the goods and services that we buy.

Now that the security is out of the hands of the ‘quant’ let’s place ourselves in the shoes of the banker and his employee the trader. The banker wants to increase the turnover and the profits of his bank. His traders are given incentives to make as much money as possible through large bonuses. The trader is not concerned with what is in the derivatives he trades. He is simply trying to buy these things at one price and sell them at a higher one (or if prices fall, he may attempt to sell them at the higher price and then buy them back more cheaply).

Market Watch (summarising the Bank for International Settlements) says that over five years the derivatives market worldwide rose to over $500,000,000,000,000 dollars ($500 trillion) in 2007, five times what it was at the start of that period. (Of course, the figure will be lower now.) This is the total of all the debts that participating banks owe to each other, back and forth. This value was created from shifting an estimated $11 trillion dollars of risk (that real lending again).

Another way of looking at it, because the derivatives market is unregulated and the securities can be freely traded, banks created $500 trillion dollars of private money, in addition to the money that is regulated by central banks. In comparison the annual Gross Domestic Product of the entire world – all the goods and services that are bought and sold – was  about $50 trillion in 2007. (The stock markets worldwide totalled about $100 trillion and real estate about $75 trillion.)

It is hard to see this as anything other than a bubble. Prices rise because other people also want to buy the things you want to buy.  Traders are individualistic, but trading on a rising market is a co-operative phenomenon – they work together to push the price up, regardless of any underlying value. It is like the art market, where people are buying works of art not because they want them but because other people want them, and therefore the value is expected to go up. Only in this case the art works are all wrapped in brown paper.

And a bubble must burst. Either some of the traders will lose their nerve, or some of the participants will find the risks they have taken on are too big for them and have to sell heavily. It’s much like the dot.com bubble of about a decade ago, but that was part of the stock market – this market is much bigger. Some big banks had too many debts, and have failed. Others are unwilling to lend because no-one else wants to lend – a cooperative phenomenon like a bubble in reverse.

According to reports the card that fell and brought down the whole house of cards was the ‘sub-prime’ mortgage market in the US, home loans with a high risk of default. The actual default was not large in economic terms, perhaps a few hundred million dollars, small change for the US government. People being as they are, there will be scapegoats named (in the UK, Iceland currently has the leading role).

You will see many theories to explain the collapse, and these will depend on the entrenched positions of the people who put them forward. Libertarians and conservatives will find ways of blaming governments, and those in favour of regulation will blame the ‘free’ market. What does seem to be the case is that there is no real theory of economics based in reality, despite what you read in the textbooks. Maybe I’ll come back to that later.