Economics 17: anatomy of crisis
by George Hatjoullis
Economic crisis may be triggered by many events. However, the transmission from event to crisis is invariably via the financial system. The crisis can also originate from within the financial system. It is not always possible to precisely determine cause and effect but the invariable role of financial markets in the transmission of economic shocks has left a popular impression that the problem lies within the very nature of financial markets. In some important respects the popular impression is correct. Economics 16 outlined the role financial markets play in the economic system. The central role is to redistribute risk that exists, from those that do not want it to those that do want it, at a price. The risk taker holds money capital, or equity, as a buffer against this risk absorbing activity and through the process earns a return on the money capital. From this characterisation one can see that the money capital of the risk absorber acts as ‘shock’ absorber, protecting the economic system from disruptive events or ‘shocks’. If a systemic economic crisis does result from an event then the absorption function of the financial markets has failed.
The absorber of shocks is equity. The contributor of equity takes a share in the risk, and subsequent reward, arising from economic activity. Other things being equal, the greater the equity the greater the shock absorption capacity. The corollary is that the greater the leverage then the lower the shock absorbing capacity of the system. Leverage, or gearing, arises through the use of debt finance. Debt allows people to finance activity in return for a fixed contractual obligation rather than a stake in the success or failure of the enterprise. The debt obligation remains whatever and has a lingering effect even under bankruptcy. Through leverage, debt also makes the system more vulnerable to shocks. To illustrate, consider home ownership. This is typically financed via a mortgage. The owner contributes a percentage of the cost of purchase (equity) and borrows the balance via a loan secured on the property. This is a leveraged transaction. The buyer with £10k cannot buy a property, but by borrowing £90k secured on the property it is made possible. The borrower has a fixed contractual obligation in terms of debt repayment and interest. If the terms are not met the lender can seize the property and sell it in order to recover monies owing. In these circumstances the buyer may lose not only the £10k equity but more, as well as the home. A shock might render the buyer unemployed and unable to meet the payments. Had the buyer rented, the equity of £10k would be available to fall back on until able to find another job and there would be no residual debt. Renting and having £10k in the bank is less risky than using the £10k to leverage to own a home. Collective leverage in the system renders the system more vulnerable to shocks and there can be no leverage without debt.
Financial crises are invariably debt crises. A system composed entirely of equity finance would not experience a crisis from a shock. This not to say that there would be no economic consequence. The discovery of a form of energy that rendered fossil fuels redundant (as energy) would have economic consequences even if all production were equity financed. However, the equity is there to take the loss. It is designed to do so. The industrial decline of the fossil fuel industry would have employment implications and reduce incomes for those dependent on this industry. However, this is ‘structural’ change arising out of innovation. It is not a crisis. Over time price incentives would see resources shift away from fossil fuel energy production and into other sectors. This is the very essence of the market based system of production and resource allocation. It is not a crisis. Looked at this way one can see that the theoretical world of the textbook is an equity financed world. Equity finance, however, is not universal. Debt finance is everywhere.
Individuals and corporations are not unaware of the increased exposure arising from debt. Moreover, the debt is not the catalyst for crisis. Something needs to happen to trigger the cascade of debt-laden collapse. Each individual and corporation no doubt carefully assesses the probability of an event that will cause them financial embarrassment in judging how much debt to use in financing their activities. However, two problems arise. First, relevant events do not fit into well defined probability density functions. This would require that all possible events are known and are distributed in a way that can be defined. There is always some residual uncertainty about the set of possible events and the distribution of such events. A lot of calculations proceed as if probabilities can be precisely and meaningfully calculated and ignore this uncertainty. This failing of the system is acknowledged but largely ignored.The Black Swan refers to events that are simply unexpected. The ‘fat tail’ refers to the greater frequency of extreme events, which may be known, than is implied by the assumed probability distribution. Both ideas say that people habitually underestimate risk through ignoring residual uncertainty. The second problem is that individually sensible decisions may not be collectively beneficial. This links back to the issue of moral hazard. A bank sensibly forecloses on an individual defaulter and sells the collateral. If it does not do so it risks encouraging others to also default because there is no consequence. However, if the banking system forecloses on many defaulters it may actually make matters much worse. Sensible micro decisions may be catastrophic in aggregate. The recognition of these two problems has led to waves of regulation over the decades but, as everyone is aware, this has yet to stop crises occurring. Indeed the action of authorities may have at times contributed to the crises.
Let us consider an endogenously generated form of crisis arising through financial markets. Markets can become dominated by a singular view of the future. Everyone can become convinced that prices can only go higher. They may borrow to invest in the asset in question. In the early days prices will be moved higher simply by the force of efforts to purchase the asset. No one will wish to go short or sell the asset. The leveraged investors initially make money and the bubble persuades more and more to borrow and buy. The process can continue for years and make a lot of people wealthy. In such environments, the price of volatility (implied volatility) typically falls (recall volatility refers to the likelihood of price moves in either direction). The illusion of a low risk, one-way bet becomes endemic. The behaviour is not necessarily irrational. It may arise because central banks promise low interest rates for the foreseeable future. The market may come to believe that the CB will do nothing to upset the market. The asset price might become extended beyond that which rational investors believe is sustainable but the fear of missing out is as strong as the fear of loss, especially if one is judged against one’s peers. Then something happens. The something may in itself be quite innocuous. It is a snap of fingers awakening the market from a hypnotic trance. The accumulated and leveraged investments now need to be unwound. If however the attempted unwinding happens quickly (which it will) then it is tantamount to too many people trying to exit via revolving door at once. No one leaves and the door gets stuck. The market fails.
Market failure is quite distinctive. It is impossible to transact much volume and certainly not in the amount desired. Attempts to transact merely push prices away from those initially quoted. This is quite deliberate as anyone obliged to quote will ‘bid to miss’ (if failure is a bear market) and will quote minimum amounts. Price falls will trigger mark-to-market losses that may have economic consequences. Typically the mark-to-market losses will necessitate further sales simply making the situation worse. A cascade of price falls ensues. The inability of investors to liquidate the asset in the failed market may force them to liquidate assets in totally unrelated markets in order to cover losses (especially if they are leveraged). This will spread the problem if there is leverage throughout the market system and may trigger other markets to fail. Losses will arise and the solvency of some participating institutions will be called into question. This introduces counterparty concerns and may reduce the ability to transact further and across a wide range of markets.The lack of transparency allows fear and rumour to prevail and a condition of perfect uncertainty to arise. The whole financial market system may become paralysed. Very soon there is a system wide crisis. This should all sound very familiar to anyone that has been awake and on planet earth since August 2007!
Crises have many components but they all involve leveraged economic agents. It is the leverage that necessitates action in response to losses and spreads the original problem wider. Incorrect risk calculations lead to excessive leverage and sets up the conditions for market failure. Once a market fails, the leveraged system will experience a cascade of problems that will spread the initial failure across the system. Leverage dilutes the equity buffer and leaves the system more vulnerable to shock. This does not mean debt should be banned. It has many advantages and that is why it has come to be such an important element of the financial system. Without leverage few would own their own homes or manage to start small businesses. However, a leveraged system will always be prone to system wide financial crises and no regulatory regime has yet been devised that can entirely eliminate this possibility. It is unlikely that a regulatory system will ever be devised that can entirely eliminate the risk of financial crisis.