Myths about the Wall Street crisis

In: Uncategorized

16 Sep 2008

Since the troubles on Wall Street at the weekend many key notions have been repeated as the accepted wisdom. However, on closer examination they are both old and inaccurate.

* Myth one: recent developments prove that Wall Street is nothing but a giant casino. This notion was stated explicitly by John McCain, the Republican candidate in the American presidential race, when he argued that the American worker has “been betrayed by a casino on Wall Street”. He was, probably unknowingly, echoing the ideas of Susan Strange, a leftist thinker, who in 1986 had an influential book published entitled Casino Capitalism.

In fact as I argued in my book Cowardly Capitalism (Wiley 2001) the contemporary financial markets are characterised by risk aversion rather than a hunger for big bets. This is much more than saying the markets are simply fearful. Rather I argue that the main reason for existence of financial markets has changed from raising capital to transferring risks. Financial markets used to provide a mechanism for businesses to raise funds or for individuals to obtain funds if they needed them. Today the purpose of many financial instruments is to transfer risk from one party to another.

This “cowardly” nature of the financial markets explains why the financial crisis has spread in the way that it has. Repackaging or “securitising” mortgages initially provided a way for lenders to sell on the risk to other parties such as investment banks. In the short term this had what was seen as the desirable effect of diversifying risk. But the risk was simply transferred rather than disappearing. Once problems emerged it could spread more easily from one institution to another. This explains what is sometimes misleading referred to as a “contagion” effect or virus in the market.

* Myth two: the markets were driven by greed. It would be more accurate to say that the developments are driven by fear rather than greed. However, it is not fear in the sense of a timeless human emotion. Rather it is a general climate of anxiety in contemporary society that affects the financial markets as everyone else.

* Myth three: it is all about confidence. It is true that confidence plays more of a role in the financial markets than in the economy as a whole. But it is a mistake of exaggerate the importance of confidence in the resolution of the crisis. The strength of the underlying real economy is a key factor to consider when trying to determine the likely outcome. The contemporary economy has a weak growth dynamic but it is not facing any fundamental crisis. It is characterised by sluggish growth but there are no signs of collapse.

* Myth four: it all started with irresponsible American subprime mortgage lending. The crisis is routinely blamed on irresponsible lenders and reckless borrowers whose debts have now gone bad. According to this caricature a combination of greedy bankers and “trailer trash” are to blame for the crisis. In reality the American housing bubble was simply a response to the low interest rates maintained by the Federal Reserve earlier this decade. This loose monetary policy was in turn a way of keeping an otherwise sluggish economy going by means of promoting a consumer boom. The fundamental problem was therefore a weak economy rather than subprime borrowers or lenders.

* Myth five: The recent actions of the American authorities, particularly last week’s bail-out of Fannie Mae and Freddie Mac, represent an end to the free market on Wall Street. Several commentators have bemoaned the fact that the American authorities have taken a strongly interventionist stance on dealing with the financial crisis (see recent posts). However, even on Wall Street, despite its reputation as a bastion for free markets, state intervention has long been pervasive. The American authorities intervene in the economy in numerous different ways and tightly regulate the financial markets. Indeed, as argued above, the roots of the current crisis can partly be attributed to the earlier actions of the Fed.

Comment Form