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The Credit Crunch of 2008

by Anthony Arkell

The media and the politicians, economists and philosophers have produced a thunderstorm of comment since the banking crisis of 2007 and 2008, most dramatically so after the demise of Lehman Brothers, the investment bank, in September 2008.

Although earlier other institutions had been supported by one means or another a change of tack by Paulson in the USA resulted in a deliberate policy to allow a major bank to fold and for shareholders to lose their whole investment.

It has been argued that shareholders should expect to lose their shirts if a venture goes bad. This is the nature of risk. But others have argued that the financial institutions are different because they are responsible for creating the lubricant – credit – that oils the wheels of the rest of the economy. And if there is no oiling then all other commerce comes to a grinding halt.

We have just seen a dramatic example of this crunching. And it was not just the lack of credit, but the fear of loss of credit that did most of the damage.

In the end it was politicians, advised by economists, around the world getting together a coherent plan to recapitalise the banks that returned the world to some kind of normality. How normal, or how abnormal for how long, we have yet to see.

At the time of writing the markets for most ‘claims on wealth’, and particularly those claims which rely on uncertain future income streams, are trading at much lower prices than a few months ago. In particular share prices, real property, and even bank deposits. Meanwhile other indices such as exchange rates vary wildly on fears of advantage or disadvantage to the holders of one or other of the world’s currencies.

Uncertain times, indeed.

As I argued in my book, The Real Questions, it should be no surprise that trade goes through a cycle of expansion and contraction. That is the nature of innovation. Goods and services have lifespan. Some short and perhaps trivial; others enduring for generations. Even the staples of life – food and clothing and shelter – vary with each period. One only has to read advertisements in a publication of a few decades ago to see that what was on the market then is now obsolete or totally changed. Similarly the television, computer and ipod that is with us today may be superseded or beyond recognition in ten years time, or even less.

Such changes are desirable, quite natural, and innovation ensures that the good endures or evolves and the less good fade away.

Cycles apply to services as well as goods. Buy-to-let mortgages are an example of innovation in recent times. Always doomed to lead to disaster in my view. Insurance products are constantly evolving. Recycling of materials can be regarded as a service although not a purely paper-based one: an innovation necessitated by the growth of economic activity and the need to conserve fundamental matter for reuse.

Then there are derivatives of paper-based services. Mortgages led to SIV’s – securitised investment vehicles – which few knew about and even few understood what was being sold. No doubt they were presented by the sellers as a nice way for those with a desire for high and steady income streams to benefit while at the same time having an appreciating asset.

The Real Questions showed how capitalisation of Rent leads to distortions throughout the economy with various serious repercussions. If Rent is not capitalised, there is much less need for mortgages. And no expectation that credit created to finance “big-ticket items” such as buildings would appreciate in value. They would be a wasting asset. Under this scenario the chance to create clever derivatives to be sold to an unsuspecting second tier of financial institution would not exist.

Throughout history the foolish, the greedy and the fearful have traded with each other in ways which seem ludicrous today. Tulip bulbs in Holland, shares in non-existent companies in the South Sea Bubble, and more mundanely the lotteries run by many local, national, or regional bodies. All are traps for the unwary. I have no expectation that if Rent is not allowed to be capitalised all scams will disappear, but I would expect the populace to be less prone to falling for such scams when they are self-sufficient, properly remunerated for effort and careful of their money so that they can look after themselves and their families.

What can we expect from the aftermath of the 2008 credit crunch? It will take time for something approaching normal trade to resume. At the time of writing the chattering classes are busy finding as many scares as they can, even when the everyday economy is carrying on reasonably well.

If the capital structure of the banks has been stabilised they at least should be lubricating the needs of the industry and commerce that needs credit. Total credit in the economy will be less because crashes cause calamities for some, and that wealth will be snuffed out.

In so far as major institutions were saved from bankruptcy by injection of taxpayers funds the funny money those institutions created will be perpetuated feed into the money supply causing inflation. Inflation in the true sense that is: a loss of purchasing power of a unit of money. This has already caused a depreciation of the currencies that are perceived as being most diluted. As an aside, inflation is often spoken of as something other that a dilution of money value. If demand for oil or wheat pushes price for those commodities up, as happened at the end of the recent boom, that has nothing to do with inflation. On the reverse side the import of cheap manufactured goods from China is not a measure of low inflation in the UK or USA, it is a result of very unequal terms of trade. (This subject was also discussed in The Real Questions.) It was a transparent folly of the bankers and politicians to cite cheap imports fro China as evidence of low inflation, and led to much lower interest rates for much longer than was wise.

We can expect the central bankers to react as wrongly in the future as they did in the recent past. The falling currency will be seen as a danger for inflation. In fact it is symptom of past inflation (money dilution). Interest rates will probably be held higher than they could or should be for revival of trade and of confidence.

Without confidence at all levels: consumer, entrepreneur, and investor, demand will be weaker for longer than it need be. It is worth reflecting that the needs, wants and desires of individuals has not suddenly evaporated. We still want good food, in variety, good clothes in fashionable exciting shapes and shades, holidays in congenial and exotic or tranquil places, housing in modern and well-designed units in desirable locations. An economy is about each of us combining with others to provide the wants and desires of our neighbours; nationally and internationally.

The Real Questions explored why that very natural and obtainable type of economy does not exist. The systemic failure of credit creating institutions which arose, but which could not have arisen in a wholesale way if Rent were unable to be capitalised, has exploded the puffball of an economy based on a flawed system. Slowly, too slowly for the needs of many, the economy will be rebuilt, but with all the old imperfections. And although the next failure may manifest itself in a different way, it will all happen again in the future. Unless…. ah, yes, unless someone shows the way to a more sensible way to order our affairs!

© Anthony Arkell 2008

©Anthony Arkell 2008

robin@anthonyarkell.com