What's started to happen to global financial markets is very serious. Also, to anyone who knows the history of capitalism, it’s very familiar.
Put simply, at the end of last week, a lot of banks ran out of money. The global financial system is fuelled by banks lending to each other.
Last week this crucial inter-bank market dried up. Banks had been stuck with bad loans to the so-called subprime mortgage market in the US.
Subprime is the market developed to provide housing loans to borrowers with bad credit records. The theory was that the banks would package lending to the subprime market into complex financial instruments known as collateralised debt obligations (CDOs) and sell these to hedge funds and the like.
But the subprime market collapsed early this year. The banks have therefore been landed with loans that they couldn’t sell on. For the past few weeks the financial markets have really started to panic about the consequences.
Financial markets work according to supply and demand, just like any market. As money became scarce, interest rates started to rise. This forced the central banks to start intervening.
The European Central Bank was first, responding to the plight of some European banks with bad loans that are being shunned by their US counterparts.
It pumped 95 billion euros into the market on Thursday of last week, then another 61 billion euros on Friday, at the height (so far) of the panic.
The US central bank, the Federal Reserve Board, had held back – earning increasingly vicious attacks from scared dealers. But on Friday it too moved, lending $38 billion and accepting mortgage securities in return.
Much attention has been paid to the role played by CDOs and other so-called credit derivatives in creating the conditions for the panic. But despite this fancy financial engineering, the dynamics of the crisis are very familiar.
Low interest rates, such as those that have prevailed for much of the present decade, make credit cheap. This encourages investment in apparently profitable ventures.
If cheap credit coincides with the recovery of the real economy from a recession, as happened in the US after 2000-1, there will probably be a lot of genuinely profitable opportunities. But as the cycle continues there are fewer sure things to invest in.
Riskier – indeed plain dodgy – deals become attractive. The subprime market is a classic example. Eager to sell mortgages, brokers didn’t bother to make credit checks on their customers.
Sooner or later however the bubble bursts. The trick, for the smart speculator, is to spot when to get out. Chuck Prince, boss of Citigroup, expressed this philosophy very well a few weeks ago.
He said, “When the dancing stops, things are going to get complicated. But, as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
When the dancing stopped, it emerged that Citigroup lost more than $700 million in the credit markets last month.
Unfortunately this isn’t a game. The entire economy can sink into a recession under the weight of bad investments made when the financial markets are dancing.
Commentators keep saying “the fundamentals are sound”. As the Financial Times put it last Saturday, “The underlying economy, and growth prospects, remain in good shape.”
It’s true the world economy has been growing quite quickly in the past couple of years. The credit boom in the US fuelled demand for the cheap manufactured goods now produced on a vast scale in China.
China in turn imported plant and equipment, especially from Germany and Japan, pulling these economies out of long periods of stagnation.
So the US economy remains the engine of global capitalism. It was already slowing down before the credit crunch of the past few weeks. If the central banks fail to restore financial stability quickly, we could all be in for a bumpy ride.