Sunday, 21 September 2008

The Financial Crisis

I know I should resist the temptation to comment on something where it's most unlikely I'll have anything to say that hasn't been said by many others, but I'm commenting nonetheless.

Much discussion overlooks the root of the crisis, by concentrating on the mechanism by which it developed.

People talk of financial instruments so complicated that hardly anyone could understand them, and people selling banks shares short, and the need to regulate someone or other to stop it happening again. I wonder whom should be regulated and how ? The present British Government changed the regulatory system for financial institutions when it came into office in 1997. Had it wished it could have made further changes at almost any time in the last eleven years. What does it now wish it had done differently ?

The problem is bad debt and certain bad debts in particular. Although many institutions owe each other great sums of money, at the root of the problem are mortgages that exceed the market value of the property on which they are secured. If there is to be more regulation, the obvious move would be to set a maximum proportion of the purchase price of a building that can be met by a mortgage. - 85% perhaps ? I haven't heard anyone suggest that, yet without reckless lending to house buyers, the whole process could not have started.

It would indeed have helped if banks had abstained from buying securities they didn't understand, but it might be hard to draft, and even harder to enforce, regulations imposing an obligation to understand anything.

Particularly silly is the widespread criticism of short selling. At most that affected share prices, yet it was not the falling share price that made Lehman's insolvent; quite the opposite. It was a suspicion that the company might be insolvent that depressed the share price. In so far as short sellers accelerated the price fall, they were not creating a problem, but drawing attention to a problem that already existed before they started trading.

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