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December 2, 2007

The Thing to Fear is Lack of Fear

Martin Wolf says that without fear, financial markets "go crazy":

Fear makes a welcome return, by Martin Wolf, Commentary, Financial Times: ...Panic follows mania as night follows day. ... Ours has been a world of ... confidence, cleverness and too much cheap credit. This is not new. It is as old as financial capitalism itself. The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with “displacement”, some event that changes people’s perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.

The fourth stage is over-trading, when markets depend on a fresh supply of “greater fools”. The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry “bubble” are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.

In the latest cycle, displacement began with the huge cuts in interest rates in the early 2000s, which drove up prices in housing. The easy credit was stimulated by innovations that allowed those making the loans to regard their service as somebody else’s problem. Then people started to buy dwellings to resell them, not live in them. Subprime lending was a symptom of euphoria. So, in a different way, was the rush of bankers into hedge funds and of the wealthy and big institutions into financing them. Then came profit-taking, falling prices and, last week, true revulsion.

This was what George Magnus of UBS bank calls a “Minsky moment” . It was the moment when credit dried up even to sound borrowers. Panic had arrived.

The correct policy response is also well known. ... The central bank must save not specific institutions, but the market itself. It must advance money freely, at a penal rate, on good security.

In providing money to the markets last week and this, the ... central banks have been doing their jobs. Whether the terms on which they have done this were sufficiently penal is another matter.

Financial markets, and particularly the big players within them, need fear. Without it, they go crazy. Moreover, it is impossible for outsiders to regulate a global financial system riddled with conflicts of interest and dominated by huge derivatives markets, massive trading by highly leveraged hedge funds and reliance on abstruse mathematics and questionable statistical models. These markets must regulate themselves. The only thing likely to persuade them to do so is the certainty that the players will be allowed to go bust. ...

The world has witnessed four great bubbles over the past two decades – in Japanese stocks in the late 1980s, in east Asia’s stocks and property in the mid-1990s, in the US (and European) stock markets in the late 1990s and, finally, in the housing markets of much of the advanced world in the 2000s. There has been too much imprudent finance worldwide, with central bankers and ministries of finance providing rescue at virtually every stage.

Unfortunately, there is every chance of repeating mistakes. A bail-out has already occurred in Germany... More are likely. US legislators want Fannie Mae and Freddie Mac to bail out the mortgage markets.

The pressure on the Federal Reserve to cut interest rates will also grow. ... The consequences [of this implosion] cannot be “ring-fenced”, as those of LTCM were. Trust in counterparties and financial instruments has fled. The likelihood is a period of recognising losses, tightening credit conditions and deleveraging.

Such a period, desirable in itself, will lead to strong pressure for swift declines in interest rates, at least in the US, and so for another partial bail-out of a crisis-prone system. This pressure should be resisted as long as possible. ...

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