Geoffrey Hosking: The 'credit crunch' and the importance of trust
[Geoffrey Hosking is a historian of Russia and the Soviet Union and formerly Leverhulme Research Professor of Russian History at the School of Slavonic and East European Studies, University College, London. geoffreyhosking@mac.com.]
The so-called 'credit crunch' which began in the summer of 2007 has now evolved into something altogether more significant and disturbing. A climax of sorts was reached on 7 September 2008, when Hank Paulson, Secretary to the US Treasury, announced that the Federal government would be guaranteeing the debts of Fannie Mae and Freddie Mac, two institutions which provided the financial backing for some 80% of recent US mortgages. A right-wing Republican administration, champion of the free market, had in effect nationalised the largest financial institution in the country; there could be no clearer indication that this is the biggest financial crisis since the 1930s. There swiftly followed the collapse of Lehman Brothers, the greatest corporate bankruptcy in history, the forced take-over of Merrill Lynch and the emergency rescue of the world's largest insurance company, AIG. Therewith three of the top five US investment banks went under (Bear Stearns, a third, having already sunk in March). Meanwhile, the UK's largest mortgage lender, Halifax Bank of Scotland, was taken over by Lloyds TSP to prevent its collapse.
Stock markets have plunged. In the USA and UK, and in other European countries, banks and building societies have accumulated unknown amounts of 'toxic debt', deriving from subprime mortgage deals. So far they have written off some $500 billion of debt, and they are still counting. As a result they are reluctant to lend money to one another or to potential house-buyers, since they can no longer be sure who can pay back whom and when. They even find it difficult to realise the assets in their portfolios, since selling them drives down the price and degrades those assets. House prices decline, and with them owners' confidence in their own wealth, and their ability to raise loans quoting their homes as collateral. Builders, retailers and manufacturers are all facing tighter markets and laying off some of their employees.
Much of this was foreseen in a book published six months before 'black September'. In The New Paradigm for Financial Markets George Soros asserted that what has happened is the bursting of a 'super-bubble', climax of the successive booms and busts that have disrupted financial markets at various junctures in the last quarter of a century: Latin American debt after 1982, the Savings and Loan Association crash in 1986, the Asian and Russian crises of 1997-8 and the dotcom bubble of 2000. In each case except the last the IMF and/or national central banks have had to step in to restore a stability that the market was incapable of recreating unaided. Soros argued that under the influence of market fundamentalism - the misguided belief that markets should be given free rein because they are self-correcting and tend towards equilibrium - credit had expanded to the point where it was dangerously unsustainable. He believed the time had come for the super-bubble to burst, provoking a crash which would be as serious as the slump of the early 1930s, though it would take different forms and would be tackled in different ways.
Soros explained the fallibility of the market through what he called 'reflexivity'. Participants in any activity, including finance, cannot simply stand back and study their situation with entire rationality and with full information at their disposal; they are bound up in the process, and they have to use what information they have before them - inevitably always inadequate and imperfect - to take decisions. They are therefore bound to make mistakes, and in finance those mistakes will tend towards self-reinforcing over-optimism about what credit can achieve. Furthermore, their actions change the reality they are assessing. Selling the shares of a poorly-performing company is not only a rational response to reality; it also changes that reality by helping to drive the price yet further down. Self-reinforcement thus works in both directions.
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The importance of trust
I believe Soros is right, but has not fully identified the force driving financial markets, which is trust. Trust is one of the most pervasive, but also least noticed, features of social life. We all exercise it unthinkingly every day. For forty-one years I have been trustingly paying substantial sums each month into a pension scheme, without getting a penny in return. Fortunately my trust was justified: when I retired a few months ago, I started to see the benefit.
Life is full of these more or less routine exercises of trust. As Soros remarked, seldom if ever can we obtain all the information we would need in order to take decisions in a fully rational manner. Even when we ponder decisions carefully, at a certain point we have to stop seeking further information, say 'enough is enough' and take a decision based on what we know and how we feel. The way in which we do this is strongly influenced by the society in which we live, its customs and its culture. Furthermore, trust has its own dynamic: it is usually self-reinforcing. We go on trusting beyond the point at which evidence suggests distrust would be more appropriate. Trust is not infinitely elastic, though: eventually counter-evidence has its effect and we turn to distrust, which is equally cumulative and self-reinforcing. This is exactly what has been happening in financial markets.
The paramount symbol of trust in modern society is money. It enables us in normal times to obtain goods and services from people we do not know, have no other grounds for trusting, and are never likely to meet again. Anyone who lived through German hyperinflation in the 1920s or Russian hyperinflation in the 1990s can tell you what absurd and cumbersome devices people have to adopt, if money cannot be trusted, to obtain daily requirements that we take for granted.
But money is complex and many-layered. Much of the money most of us possess takes the form of an entry in electronic account records. Behind that is paper money, which many people think of as 'real money', even though no bank keeps enough of it to satisfy its customers, should they all turn up together to withdraw their funds. But that money is not really 'real' either. Each note bears a statement that the Bank of England 'Promises to pay on demand the sum of' - ten pounds, let us say. That promise refers to reserves of gold that the Bank of England holds - except that the Bank does not hold anything like enough of it to cover all the banknotes in circulation, and anyway it long ago cancelled its obligation to offer gold in return for notes. Even if it still did, what can you do with gold? You can't eat it, or wear it, or warm yourself with it. So money is not a real 'good' or benefit, just a symbol of entitlement to a benefit, a symbol which society trusts, even though it is at least one stage removed from that benefit. The current voracious demand for gold shows that in uncertain times we feel safer descending several storeys in what begins to look like a rickety structure....
Read entire article at History & Policy
The so-called 'credit crunch' which began in the summer of 2007 has now evolved into something altogether more significant and disturbing. A climax of sorts was reached on 7 September 2008, when Hank Paulson, Secretary to the US Treasury, announced that the Federal government would be guaranteeing the debts of Fannie Mae and Freddie Mac, two institutions which provided the financial backing for some 80% of recent US mortgages. A right-wing Republican administration, champion of the free market, had in effect nationalised the largest financial institution in the country; there could be no clearer indication that this is the biggest financial crisis since the 1930s. There swiftly followed the collapse of Lehman Brothers, the greatest corporate bankruptcy in history, the forced take-over of Merrill Lynch and the emergency rescue of the world's largest insurance company, AIG. Therewith three of the top five US investment banks went under (Bear Stearns, a third, having already sunk in March). Meanwhile, the UK's largest mortgage lender, Halifax Bank of Scotland, was taken over by Lloyds TSP to prevent its collapse.
Stock markets have plunged. In the USA and UK, and in other European countries, banks and building societies have accumulated unknown amounts of 'toxic debt', deriving from subprime mortgage deals. So far they have written off some $500 billion of debt, and they are still counting. As a result they are reluctant to lend money to one another or to potential house-buyers, since they can no longer be sure who can pay back whom and when. They even find it difficult to realise the assets in their portfolios, since selling them drives down the price and degrades those assets. House prices decline, and with them owners' confidence in their own wealth, and their ability to raise loans quoting their homes as collateral. Builders, retailers and manufacturers are all facing tighter markets and laying off some of their employees.
Much of this was foreseen in a book published six months before 'black September'. In The New Paradigm for Financial Markets George Soros asserted that what has happened is the bursting of a 'super-bubble', climax of the successive booms and busts that have disrupted financial markets at various junctures in the last quarter of a century: Latin American debt after 1982, the Savings and Loan Association crash in 1986, the Asian and Russian crises of 1997-8 and the dotcom bubble of 2000. In each case except the last the IMF and/or national central banks have had to step in to restore a stability that the market was incapable of recreating unaided. Soros argued that under the influence of market fundamentalism - the misguided belief that markets should be given free rein because they are self-correcting and tend towards equilibrium - credit had expanded to the point where it was dangerously unsustainable. He believed the time had come for the super-bubble to burst, provoking a crash which would be as serious as the slump of the early 1930s, though it would take different forms and would be tackled in different ways.
Soros explained the fallibility of the market through what he called 'reflexivity'. Participants in any activity, including finance, cannot simply stand back and study their situation with entire rationality and with full information at their disposal; they are bound up in the process, and they have to use what information they have before them - inevitably always inadequate and imperfect - to take decisions. They are therefore bound to make mistakes, and in finance those mistakes will tend towards self-reinforcing over-optimism about what credit can achieve. Furthermore, their actions change the reality they are assessing. Selling the shares of a poorly-performing company is not only a rational response to reality; it also changes that reality by helping to drive the price yet further down. Self-reinforcement thus works in both directions.
back to top
The importance of trust
I believe Soros is right, but has not fully identified the force driving financial markets, which is trust. Trust is one of the most pervasive, but also least noticed, features of social life. We all exercise it unthinkingly every day. For forty-one years I have been trustingly paying substantial sums each month into a pension scheme, without getting a penny in return. Fortunately my trust was justified: when I retired a few months ago, I started to see the benefit.
Life is full of these more or less routine exercises of trust. As Soros remarked, seldom if ever can we obtain all the information we would need in order to take decisions in a fully rational manner. Even when we ponder decisions carefully, at a certain point we have to stop seeking further information, say 'enough is enough' and take a decision based on what we know and how we feel. The way in which we do this is strongly influenced by the society in which we live, its customs and its culture. Furthermore, trust has its own dynamic: it is usually self-reinforcing. We go on trusting beyond the point at which evidence suggests distrust would be more appropriate. Trust is not infinitely elastic, though: eventually counter-evidence has its effect and we turn to distrust, which is equally cumulative and self-reinforcing. This is exactly what has been happening in financial markets.
The paramount symbol of trust in modern society is money. It enables us in normal times to obtain goods and services from people we do not know, have no other grounds for trusting, and are never likely to meet again. Anyone who lived through German hyperinflation in the 1920s or Russian hyperinflation in the 1990s can tell you what absurd and cumbersome devices people have to adopt, if money cannot be trusted, to obtain daily requirements that we take for granted.
But money is complex and many-layered. Much of the money most of us possess takes the form of an entry in electronic account records. Behind that is paper money, which many people think of as 'real money', even though no bank keeps enough of it to satisfy its customers, should they all turn up together to withdraw their funds. But that money is not really 'real' either. Each note bears a statement that the Bank of England 'Promises to pay on demand the sum of' - ten pounds, let us say. That promise refers to reserves of gold that the Bank of England holds - except that the Bank does not hold anything like enough of it to cover all the banknotes in circulation, and anyway it long ago cancelled its obligation to offer gold in return for notes. Even if it still did, what can you do with gold? You can't eat it, or wear it, or warm yourself with it. So money is not a real 'good' or benefit, just a symbol of entitlement to a benefit, a symbol which society trusts, even though it is at least one stage removed from that benefit. The current voracious demand for gold shows that in uncertain times we feel safer descending several storeys in what begins to look like a rickety structure....