The credit crisis appears to be easing. Maybe it's not over completely, but things have improved significantly in the past seven days. It may worsen again if a large bank or two need bailouts. But, since governments around the world have declared, “Whatever it takes” it is likely that this would just serve as a temporary blip in an improving trend.
The credit crisis was manifested primarily in the unwillingness of banks to loan to each other. Interbank lending, which is critical for banks to manage their cash flows and smooth out timing mismatches between funds coming in and going out, had virtually dried up. It was available only in terms of hours—that is, banks had to repay other banks within hours—and at exorbitant interest rates.
So fearful had bank become of recipient banks going bust that they were unwilling to lend to other banks—which in more normal times is usually a highly secure, low risk form of lending. They would rather sit on cash. Why is this such a crisis, you ask? If banks cannot smooth out their shorter term cash flows, they will stop lending and hoard cash—which is precisely what was happening. All banks borrow short and lend long. If they can no longer borrow short they will hoard cash until their long lending matures. It is a only prudent thing to do. But if banks will not lend, businesses which similarly require short term working capital to manage their cash flows, meet payroll, and cover short term liabilities, will also not be able to get credit—which will lead to bankruptcies, retrenchments, layoffs—which in its turn, would lead to yet another cycle of belt-tightening, bankruptcies, retrenchments etc.
The phalanx of measures taken by governments and central banks around the world now appear to be working. Banks are staring to lend to one another again. According to The Economist, borrowing volumes yesterday were ten times what they were three weeks ago. The Economist writes:
American banks including JPMorgan Chase and Citigroup have, in the past week, made loans to European counterparts for up to three months. And HSBC, Europe’s biggest bank, says it is providing billions in three- and six-month funding to banks.
Markets for longer-term credits for banks are also gradually returning to life as institutional investors regain their nerve. On October 17th Lloyds TSB managed to sell £400m ($690m) worth of ten-year bonds—the first such issue by a European bank since the collapse of Lehman.
Gradually the interbank lending rate is coming down as well—another sign that risks, or the perception of risks, are starting to disappear.
Meanwhile the Left Wing sees its great chance. It has loudly announced the end of Capitalism. The Free Market is now a manifest failure, we are told. Mankind now needs to move to a model of a centrally controlled economy—and we will, and are! The recent government interventions are offered as a proof of this.
But before we accept that the world has ended as we know it, let's pause and think a bit harder.
Firstly, let's remember that we live in a time filled with a cacophony of jeremiads of every kind. The end of the world as we know it is now de rigueur. It is deja vu, all over again. At least once a month, some extremist or enthusiast, somewhere is announcing the end of all things. So it pays, particularly in such alarmist times, to think analytically and carefully rather than merely to emote.
Secondly, Capitalism—that system of political economy which protects private property and the private free exchange of that property—requires crashes and busts if it is to work properly. So, the mere existence of a crash or a collapse no more argues for the end of Capitalism than the presence of disease argues for the end of doctors and medicine. There are several reasons why this is so.
Joseph Schumpeter, in his iconic work, Creative Destruction, demonstrated that technological innovation and creativity allows market dominance for a time. However, subsequent innovation by competitors will lead to the destruction of the previous market leader. The seesaw fortunes of Dell and HP are a classic example of the creative-destructive pattern at work. The declension of Kodak in the face of digital photography is another. This is one of the great strengths of Capitalism, not its Achilles heel.
Moreover, the free exchange of private property (whether of capital or labour) operates within the frame of limited information and knowledge. Omniscience does not grace markets—nor anything else in the Creation. The Living God alone is omniscient. Therefore human beings, workers, buyers, sellers, manufacturers, and consumers all act with limited information. No-one can perfectly predict the future. No-one perfectly understands either the present or the past. Most people operate and make decisions on the basis of extrapolating into the immediate future what has happened in their immediate past.
If house prices rise for the past year, most people will plan their affairs on the assumption that house prices will keep rising for a few more months. If house prices rose for the past five years, most people regard it as well nigh absolutely certain they will also rise in the next twelve months. They will enter into loan contracts, purchase contracts, building contracts, and so forth, on those assumptions. This means that the more markets heat up, the more they over-heat. The more demand rises, the more it will rise—until reality sets in, and the correction occurs. Consequently, all markets overshoot. All markets go through boom and bust.
The booms and busts are exacerbated, amplified respectively when credit is either readily available, or not available at all. Of course, lending institutions (banks) are likewise subject to the same sentiments as the rest of humanity. If their credit defaults have been low for the past five years, and if profits have risen along with their share price, management is most likely to expect more of the same next year: they manage their businesses accordingly. Therefore, in good times, banks lend more easily, making the good times even better (for a time). In bad times, banks prefer not to lend hardly at all, making the bad times much worse.
It is likely that the current imbroglio will turn out to be a quite painful bust. But it needed to be—given the explosion of unbacked, paper credit which has occurred in the past ten years. But does it mark the end of Capitalism? Not at all, unless policy makers, regulators, and electorates choose to disregard the obvious. This is possible, of course.
What we expect as a more likely outcome is that the support of central banks and governments will lessen the bust—making it less severe, although acutely felt. Governments will not face huge fiscal deficits over the medium term because most of their financial support to the banking system will be returned with gains and interest.
Finally, a more rigorous regulation of the “shadow banking system” will result, requiring far much more capital backing to derivatives and similar financial instruments. This will be a very good outcome. It will slow growth going forward for a considerable time. But it will help reduce the systemic implicit fraud which has been part of the monetary system for far too long. In this regard the outcome of the meeting of nations convened by the US President is going to be particularly significant, provided sufficient progress can be made.
In the end, Capitalism can only thrive within a special ethical framework—a framework that respects private property and private exchange. But a necessary corollary of that ethical framework is that commercial exchanges must not be allowed to be deceptive or misleading. You cannot build a political economy upon fraud and deceit. Preventing, detecting and punishing deceit and fraud is the essential and vital role of government within the Capitalist system.
If governments do not maintain that duty, Capitalism will indeed have come to an end. But, if that be the case, human society and civilisation, as we know it, shall also have passed.
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