Opalesque London: Professor Richard Werner is director of the Centre for Banking, Finance and Sustainable Development at the University of Southampton (UK), CEO at Southampton-based Providence Asset Management, and author of ‘New Paradigm in Macro-economics’ (2005, Palgrave MacMillan). He gave his version of the current crisis at the Hedge 2008 conference in London last week.
The current financial crisis is not new
Even though significant breakdowns in inter-bank market are rare and the extent of the problem is great, the fundamental cause and the solutions are not new. It can be traced back 5000 years. However “this crisis is different,” said Prof. Werner.
His opinion is mirrored by others:
“There’s never been anything this pervasive, this challenging to the structure,” former Bear Stearns chair Ace Greenberg had told MoneyNews.com. The huge number of securitized mortgages distinguished the current financial crisis from its predecessors. Mortgage-backed securities created a credit problem that spread nationwide before infecting Europe and Asia.
Gerry Kramer wrote in NaplesNews.com that this crisis was different because, first, the last 25 years had been a period of vast financial innovation in world capital markets; second, gross interbank financial transactions and contracts in the US alone had totalled trillions of dollars; third, the financial world had also become inextricably intertwined; and fourth, the US economy had become addicted to credit.
Indeed, we now have complex financial products. The achievements of the free financial markets until AD 2007 include sub-prime mortgages, securitisation and ABS, credit derivatives, SIVs, SPCs. We also have highly-rated financial products that combine the above and highly-leveraged hedge fund strategies that combine the above. This time, the game of financial engineering may be over.
The specialness of banks
Money is actually extremely difficult to define, said Prof. Werner. But it can be done so when considering where the supply comes from – this is where bank play a special role. Banks are a monopoly power when compared to other financial institutions; they are not just mere financial intermediaries.
Schumpeter (1912) said that banks were the central settlement system of the economy, as they operated “a huge system of credits and debits, of claims and debts, by which capitalist society carries on its daily business of production and consumption.” Thus it is “more useful to start from the credit transactions and look upon capitalist finance as a clearing system that cancels claims and debts and carries forward the differences – so that money payments come in only as a special case without any fundamental importance.” In other words, credit is the key.
Banks act as accountants of the economy and have the ability to individually create credit – out of nothing. “This is how MOST of our money is created – out of nothing,” Prof. Werner added.
Good and bad credit creation
The credit market is rationed by banks and supply-determined. “There will always be demand for credit,” he said. As credit is created, its quantity is the key budget constraint on activity and thus determines growth, asset prices and should be used for policy.
Prof. Werner proposed that in the standard equation of exchange (money supply = nom. GDP), ‘money’ should be replaced by ‘credit’ and that we should distinguish between credit used for real economy transactions and credit used for financial transactions. Unproductive credit creation should be avoided and productive credit creation should be the focus, as credit flows are the source of boom and bust cycles.
The types of speculative credit creation include margin loans, loans to non-bank financial institutions, credit for real estate speculation, loans to SIVs, to hedge funds, to PE funds, for M&A and direct financial investments by banks.
Bubbles and crisis
A bubble economy arises when the proportion of financial credit creation rises, which creates capital gains from speculation and bolsters balance sheets. This is when we have the myth of the continually rising asset price.
Banking crisis and debt deflation arise when the creation of speculative credit suddenly drops, which is usually triggered by central banks. This is when the vicious cycle starts. Past banking crisis due to speculative credit creation occurred in the US (1920), Scandinavia (1980s), Japan (1980s), Asia (1990s). And this side of the century, we saw property bubbles in the UK, the US, Ireland and Spain.
What’s new with the current crisis?
Thanks to securitisation and credit derivatives, banks acquired a greater appetite for speculative credit creation, for greater risk (which was largely underestimated) and for direct financial speculation. So “the sheer scale is new,” he said.
Also, the US scrapped the Glass Steagall Act of 1933 which meant banking and securities speculation could once again mixed together. Basel II also gave an incentive for banks to engage in direct financial speculation.
Responsible parties: central banks
The creation of bubbles can be prevented by monitoring and targeting speculative credit creation – which is something that central banks used to do. But after t......................
Source:
http://www.opalesque.com/AMB2008/48028Richard_Werner_Crisis_started_with_speculative.html
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