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Commentators and policy-makers are still talking in terms of risk. Markets, they say, need to reassess and reassign risk across securities and companies. But, in reality, markets are now operating under uncertainty. No one really knows where the boundaries of the problem lie, what surprises are in store, or what measures will be adequate to stop the bleeding. And the U.S. Fed is making policy on the fly."
Breaking News from The Globe and MailGlobal capitalism teeters on the brinkWe've moved from a world of risk to a world of uncertaintyBy Thomas Homer-Dixon
Wednesday, March 19, 2008
SourceThe U.S. central bank is slashing interest rates, accepting piles of near-worthless securities from commercial banks as collateral for emergency loans, and pumping hundreds of billions of dollars into the economy. A problem that began last summer in the lowest-grade U.S. mortgage market has spread around the world, moved relentlessly up the quality ladder and sucked credit from the global financial system like oxygen from a flame. Each intervention by U.S., European, Japanese and Canadian central banks to stabilize the situation has been swamped by surprises that have escalated the crisis to a new level.
Over the weekend, experts talked about the risk of the financial system's wholesale collapse. Some even drew parallels between today's situation and the credit crisis that produced the Depression.
What's going on? Are we simply in the midst of another gut-churning fluctuation of a world economy that's prone to intermittent volatility but that always seems to find its footing? Or are we glimpsing a deeper emergency, one that goes to the heart of modern global capitalism?
The U.S. Federal Reserve's latest efforts may stabilize markets for the time being; stock markets were sharply higher yesterday. But there's reason to believe the crisis is the product of systemic problems in the world's economy.
Three key factors - each operating and gaining momentum over decades - have come together to cause this crisis. The first is the sheer productivity of modern global capitalism. The world's businesses, spurred by global competition and a never-ending race to boost productivity and keep costs down, excel at producing a steadily rising flood of goods and services. To ensure that these goods and services are bought and that factories and businesses keep humming, the global economy needs a constant infusion of liquidity provided by cheap debt.
Second, in the past three decades, a neo-conservative ideology that asserts markets are infallible and, as a result, disparages any kind of state regulation has come to dominate thinking about economic matters, especially in the United States. Alan Greenspan, the long-time Federal Reserve Board chairman until 2006, was an ardent advocate of this view, and it became an article of faith in powerful U.S. political and economic circles - not surprisingly so, since it justified letting economic elites pursue their interests with little government interference.
Third, enormously powerful computers and software, along with fibre-optic communication, have allowed financial wizards to conduct business transactions in the blink of an eye around the world and to create financial instruments - derivatives, swaps, structured investments and the like - of mind-boggling complexity. For all intents and purposes, these new instruments have blurred the boundaries of what we call money. Several decades ago, central bankers could sensibly talk about and, if necessary, control the money supply. Now, what counts as money isn't at all clear, and many things that look and behave like money can't be regulated.
Since the dot-com implosion and the recession in the early years of this decade, these three factors have converged in a toxic brew. Central banks, especially the Greenspan Fed, wanted to reinflate their national economies, so they looked the other way as unregulated quasi-banks created a colossal edifice of credit - a tightly coupled global architecture of debt instruments that no one fully understands. And we're now realizing that something close to endemic fraud aided and abetted this enterprise: Credit-rating agencies such as Moody's and Standard & Poor's put their triple-A imprimatur on securities underpinned by crummy assets; investment banks held major liabilities off their books; and nearly everyone in the business established the value of complex securities by reference to numbers churned out by impenetrable computer models - not by reference to prices in real markets.
So the rules of the game have now changed. Our global financial system has become so complex and opaque that we've moved from a world of risk to a world of uncertainty. In a world of risk, we can judge dangers and opportunities by using the best evidence at hand to estimate the probability of a particular outcome. But in a world of uncertainty, we can't estimate probabilities, because we don't have any clear basis for making such a judgment. In fact, we might not even know what the possible outcomes are. Surprises keep coming out of the blue, because we're fundamentally ignorant of our own ignorance. We're surrounded by unknown unknowns.
Commentators and policy-makers are still talking in terms of risk. Markets, they say, need to reassess and reassign risk across securities and companies. But, in reality, markets are now operating under uncertainty. No one really knows where the boundaries of the problem lie, what surprises are in store, or what measures will be adequate to stop the bleeding. And the U.S. Fed is making policy on the fly.
We do know, however, that we're not dealing with a liquidity problem. We face a massive solvency problem: Banks and investment firms aren't so much worried about financing their next investment; instead, they fear for their survival, because core assets - particularly loans on their books - have been suddenly and dramatically devalued. In this environment, the tools available to central bankers may not work. You can encourage people to borrow by pumping money into the economy, but you can't force people to lend.
Thomas Homer-Dixon holds the George Ignatieff Chair of Peace and Conflict Studies at the University of Toronto and is author of "The Upside of Down"© The Globe and Mail