Lord Turner Discusses The Credit Crisis

Article, January 2009

On 21 January 2009 Lord Turner, Chairman, FSA gave an excellent account of the Credit Crisis and it's cause. The speech can be found here . It's a great read but a little long so here is an attempt to create a shorted account.

What happened and why?

Turner says "I think with hindsight – and it is only with hindsight – a fairly compelling and broadly agreed explanation of what has occurred can be set out."

He describes first the macro imbalances which are the large current account surpluses which have been piling up in some Asian nations and the oil exporters, and the large current account deficits piling up in the USA, but also in the UK, in Ireland, Spain and some other countries. Total US Debt has risen to it's highest ever level of 350% of GDP. In 1980 it stood at around 150% of GDP.

However, despite this vast borrowing real interest rates in the US have remained very low, recently even hitting all time lows. The foreigners selling goods and oil to the US have been happy to accept long term US government bonds instead of cash. Part of the reason is high savings rates in countries like China, but we also have the problem of managed exchange rates which force the build up of enormous foreign exchange reserves then invested in bonds.

The high level of borrowing, combined with low real rates, pushed up asset prices especially in the housing market. Default in a rising market and a strong economy is unlikely so credit standards gradually relaxed. Also, the low real rates drove investors to ferociously seek yield by taking more credit risk. "Credit spreads on a wide range of securities and loans fell to clearly inadequate levels".

Next Turner describes the financial sector innovations of the last 10-15 years, especially the growth of securitised credit, the development of credit derivates, the growth of proprietary trading and hedge fund activity. Taking advantage of both credit derivatives and securitised credit quantitative traders developed strategies that appeared to create value but later proved disastrous.

Turner says in "the years running up to 2007, too much of the developed world’s intellectual talent was devoted to ever more complex financial innovations, whose maximum possible benefit in terms of allocative efficiency was at best marginal, and which in their complexity and opacity created large financial stability risks".

Over the past three decades the debt of the US financial sector grew six times faster than nominal GDP. The consequent increases in its scale and leverage explain why, at the peak, the financial sector allegedly generated 40 per cent of US corporate profits. These were illusory profits.

Thus Turner says that "the core of the crisis was an interplay between macroeconomic imbalances which have become particularly prevalent over the last 10-15 years, and financial market developments which have been going on for 30 years but which accelerated over the last ten under the influence of the macro imbalances".

Implications and what to do next

"Major macro-economic imbalances – large surpluses and deficits – were an important underlying driver of what occurred, and their more effective management is important not just to a more stable global system in the long term, but to the challenge of limiting the severity of the immediate economic downturn. The fundamental problem of potentially asymmetries between the policy responses of deficit countries and surplus countries, which lay at the root of the mismanagement of the gold standard in the 1920s and early 30s, and which Keynes warned of ahead of Bretton Woods, remain a crucial issue today. Without more Chinese consumption to balance more Americans saving, the deflationary impact of the crisis could be prolonged."

"Regulators were too focused on the institution-by-institution supervision of idiosyncratic risk: central banks too focused on monetary policy tightly defined, meeting inflation targets. We failed to grasp the big picture. In future, regulators need to do more sectoral analysis and be more willing to make judgements about the sustainability of whole business models, not just the quality of their execution. Central banks and regulators between them need to integrate macro-economic analysis with macro-prudential analysis, and to identify the combination of measures which can take away the punch bowl before the party gets out of hand."

Wow - no easy task - in fact I would say impossible.