21 March 2008

I’d perfectly understand if you’d rather not think about money this weekend. But you’ll probably have noticed that the words “financial crisis” have been much in the air again this week, and I think we need to try to make sense of what’s going on.

I’m one of those people who get a headache just looking at a bank statement. So this hasn’t been an easy time for me. But I labour long and hard on your behalf, and I think I’ve got the hang of it.

It goes, I think, something like this. Suppose I ask you to lend me £50. How you respond will depend in large part on how much money you have. If you don’t know exactly how much you’ve got – if you’ve already lent out oodles of dosh but you’re not sure you’ll ever get it back – well, you may politely tell me to look elsewhere. And if you’re just one of many in the same position, I’ll find it pretty tough to get my hands on that £50.

I will be, to use the technical term, the victim of a credit squeeze. And I will be in pretty much the same position as many of the world’s biggest banks. No one wants to lend, because no one is sure any more how much is in the coffers.

Last Tuesday, my colleague Jonty Bloom explained it all in wonderfully simple terms in an essay which you can either hear again via the Listen Again facility, or you can read the transcript which I’ve put online here.

Here’s the key passage: “It all started with sub-prime lending. There is a lot of ignorance about what sub-prime actually means, but it is quite easy really: sub-prime is a euphemism for rubbish. American banks lent lots and lots of money to people who couldn't pay it back because they were too poor to. That was bad enough, but the banks made it worse by then passing on the risks of not being paid back by bundling together thousands of good and bad mortgages and selling those bundles on to other banks around the world.”

Have you ever heard of a “Minsky moment”? Hyman Minsky was an American economist who used to argue that markets are inherently unstable and that if you have a long stretch of good times, you’ll just end up eventually with a bigger collapse.

His reasoning went like this: When times are good, investors feel so confident that they take on more risk. The longer the times stay good, the more risk the investors take on, until, one day, they've taken on too much. They reach a point where the cash generated by their assets is no longer enough to pay off their debts. That’s when the lenders start to call in their loans – and asset values collapse. It sounds horribly familiar, doesn’t it?

So perhaps capitalism has a built-in contradiction. It thrives on private risk – and the notion that the bigger the risk, the bigger the potential reward. But if too many people lose too much by taking on too many risks, the state has to intervene, because it’s in no one’s interests for the whole edifice to come crashing down.

The financial regulatory agencies are meant to keep an eye on the banks to make sure that they behave sensibly. But Jonty Bloom has a theory: that people’s memories are just a fraction shorter than the typical economic cycle – so that there’s always a period when they come to believe that this time things are different: that they have reinvented the wheel, that the force of gravity has been overcome.

So do yourself a favour. Write a note in big black letters, and stick it somewhere where you’ll see it every day. “What goes up, must come down.” And if you know any bankers, give them a copy too.