Causes of the financial crisis (no, its not the usual list)

Summary:  Much of the analysis of this great crisis — now clearly the worst since the 1930’s — focuses on minute, even trivial, aspects of the problem.  This is natural, as its sweep and magnitude dwarf anything seen during our lifetimes (for most of us, at least).  It has affected almost every business, kind of investment, nation — and before the end will probably affect almost every person (except those in the least developed nations).

The simple narrative for a crisis is that which came first must cause what follows.  This seems plausible, since post hoc ergo propter hoc is the default reasoning mode of the human mind.  Consider dropping colored grains of sand to form a pile.  Eventually one will collapse the pile, perhaps a green grain.  Is this then a green grain problem?  Apparently so to many people.

First this was a subprime mortgage crisis.  Then a securitized mortgage crisis.  Then a housing crisis.  Then a derivative crisis.  The crisis drags us forward to an expanding array of problems, with many experts’ eyes fixed backwards on the past.  Understandable, as looking forward is quite alarming.

Causes of this crisis

These financial shocks are byproducts of deeper trends, in my opinion.  The world has begun a process of regime change, as the foundations of the post-WWII geopolitical order decay.  Here are some of the major trends forging a new world.  Each of these has played a role in bringing us to this point; some will play an even bigger role forcing events during the next few years.

(a)  The transition from a bipolar (or unipolar) world to a multi-polar world.

(b)  Entering the transition period to peak oil, as global oil production peaked (not necessarily the peak) in 2005.  Since then biofuels have provided most of the growth in liquid fuel consumption.  Rapid GDP growth (almost 5%) required high prices to match ex ante demand with flattish liquid fuel production.

(c)  The replacement of the US dollar as the reserve currency (by what we do not yet know), after 30 years of foreign borrowing — 30 years of increasing current account deficits.

(d)  The exhaustion from overuse of monetary and fiscal policy.  Persistently too-low interest rates yielding serial investment bubbles.  The long decline to near zero of the marginal elasticity of GDP with respect to debt.

(e)  Structural weakness:  Funding long-term businesses with “hot” (aka liquid) capital, from the disintermediation of household savings.  Money shifted from vehicles where institutions bear the risk (insurance, annuities, CD’s, etc) to direct participation (owning stocks and bonds either directly or through mutual funds).   See this post for an explanation.

(f)  The Thomas Kuhn-type paradigm crisis in Keynesian economics, by which the world economies have been steered for fifty years.  The aggregate debt level of an economy is not a significant variable; attempts to integrate into orthodox theory by radical Keynesians (e.g., Hyman Minsky) were unsuccessful.  Sometime after 2000 we reached and broke though the edge of the “operating envelope” of Keynesian theory.  We ran like Wile E. Coyote off the cliff and beyond — a few exhilarating years — and now we fall.

Black Swans

How comforting to think that these were Black Swan events!  (from Wikipedia):

As formulated by Nassim Nicholas Taleb in his 2007 book The Black Swan … The term black swan comes from the ancient Western conception that ‘All swans are white’. In that context, a black swan was a metaphor for something that could not exist. The 17th Century discovery of black swans in Australia metamorphosed the term to connote that the perceived impossibility actually came to pass. Taleb notes that John Stuart Mill first used the black swan narrative to discuss falsification.

This relieves us of responsibility.  Unfortunately, none of these were “black swan” events.  All were widely predicted by experts for decades (see here for 2 dozen examples from major institutions and experts).  These warnings were made early, allowing us sufficient time to act and prevent this crisis.  The world is a large and ponderous vessel, which took generations for its internal weakness to finally capsize it.  The failure of the boat to immediate capsize following the warnings was seen as proof that they were false.

This is not a new phenomenon.  People’s impatience and short-sightedness are commonplaces in history.

On September 23 his fleet hove in sight, and all came safely to anchor in Pevensey Bay. There was no opposition to the landing. The local fyrd had been called out this year four times already to watch the coast, and having, in true English style, come to the conclusion that the danger was past because it had not yet arrived had gone back to their homes.

Description of William the Conqueror’s arrival, from History of the English Speaking People by Winston S. Churchill.  Bold emphasis added.

Alternative theories

We are at the stage where the full magnitude of these events has not yet become apparent, even to many experts.  Hence the nonsense flooding the media, attributing these great events to the most trivial of causes.  Here is a wonderful example (hat tip to Zenpundit):

Top Theorists Examine Rippling Economic Turbulence“, the PBS Online Newshour, 21 October 2008 — “As the financial sector shifts, so does the reach of the jolt to economic structures around the world. Economist Nassim Nicholas Taleb and his mentor, mathematician Benoit Mandelbrot, speak with Paul Solman about chain reactions and predicting the financial crisis.”

Much of this is correct, of course.  As in “Mandelbrot’s key insight came in the ’60s with a study of cotton price surges and plunges, suggesting the world moves in fits and starts, especially the human world.”  This is a commonly seen pattern, in both history and the physical sciences (e.g., punctuated equilibrium in evolutionary biology).

But much of this is ”inside baseball”, concentrating on the details of the financial system while ignoring the great changes in the real world — driven by forces far larger than the dynamics of our banking system.

Some of this is just wrong.  Myopia can afflict even the greatest experts.

NASSIM NICHOLAS TALEB: Let me tell you why it’s not like before. Look at what’s happening. The world is getting so fragile that a small shortage of oil — small — can lead to the price going from $25 to $150.

PAUL SOLMAN: A barrel.

NASSIM NICHOLAS TALEB: A barrel. A small excess demand in an agricultural product can lead to an explosion in price.

The world “wanted” liquid fuel growth of aprox 2% per year in 2003 – 2007.  It got 1.4% per year — 30% less.  Almost zero since 2005. (source of oil production #s:  BP Energy Review).  That is an ex ante shortage of roughly 2 million barrels per day, given oil’s low price elasticity of demand.  Sufficient to drive oil prices up quite a bit; hardly a small shortage.  this post for details.

This is not academic quibbling about the causes of our crisis.  After first aid is successful we must begin serious treatment for our global economic and probably even geopolitical systems.  At that point correct diagnosis becomes essential for a cure, and to prevent it reoccurring.


Originally published at Fabius Maximus and reproduced here with the author’s permission.

2 Responses to "Causes of the financial crisis (no, its not the usual list)"

  1. Guest   October 30, 2008 at 10:09 am

    0.6% fluctuation in the amount of oil consumed changes oil prices from $25 to 150$. There is nothing linear about that data. It is not a megatrend, as you are suggesting. It is highly non-linear. Typical charasteristics of a complex system. Sometimes insignificant change in a highly network world causes huge impacts. Megatrends should cause very easily observable linear changes. Which isn’t happening. Economy is based on interactions between individuals. A megatrend might influence their behavior, but then again it might not. Amount of oil underground has no straight effect on individual behavior. Think it little more and you will understand. You can also read Taleb’s book.

  2. Terry Mock   October 30, 2008 at 5:31 pm

    There are perhaps always a few “prophets” who foresee the unexpected. My definition of “Black Swan” is a major disruption unanticipated by the conventional experts of the time…Land Developers and Black SwansOctober 2008http://www.sldi.org/newService/SLDIOct2008.htmlby Terry Mock, SLDI Executive DirectorAs previously forecast in this column, a series of financial “Black Swans” is now upon us. These major disruptive events, which by definition were unpredicted by the establishment experts, now include the failures of Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, AIG, Merrill Lynch, Wachovia, and Washington Mutual, with more surprises undoubtedly on the way.While there have been numerous authorities working day and night to solve the problem, it is important to note that these same people were the ones that were managing the financial system in the first place. According to Professor Nouriel Roubini, no professional independent economist was consulted by Congress or invited to present his/her views at the Congressional hearings on the Treasury Department’s rescue plan. This brings to mind some words of wisdom from Albert Einstein – “We can’t solve problems by using the same kind of thinking we used when we created them”.As pointed out in the recently published book, Bad Money – Reckless Finance, Failed Politics and the Global Crisis of American Capitalism, the failure of the current financial system was not only predictable, but this same kind of thinking was also responsible for the fall of the last two global economic powers – the Netherlands followed by Britain. As is established in the book and elsewhere, the current credit crisis interrelates with our energy crisis and all the other economic failures the global economy is now suffering through. It all comes down to deficit spending by both public and private entities.Ironically, the current financial meltdown is confirmation of a prediction made in 1995 when, as a land developer and the past-president of the Florida Native Plant Society, I authored an article entitled “Earth Restoration – The Bridge to a New Global Culture“, wherein I said, “The existing world order is teetering on the brink of bankruptcy and will not be capable of sustaining itself much longer by exploiting dwindling world supplies of natural resources and by deficit government spending…The good news is that out of these huge problems will come the pressure to replace our old system with new political and business structures that will provide for a sustainable global economy”.How do we make our civilization more sustainable?As outlined in our February 2008 SLDI newsletter, “Collaborative innovation is needed to unlock the future as the world is facing a variety of challenges”, and current efforts to create new sustainable land development models hold great promise for breaking the hold of failed outdated economic ideology. According to CityscapeIntelligence, “… One of the greatest challenges is that right now we have a very low level of current knowledge about how to build sustainably in our (Middle Eastern) environment… “ On a more promising note, Cityscape reports that Masdar City, Abu Dhabi is planned to be a fully sustainable city which incorporates the highest quality of life with the lowest environmental footprint. Masdar City will be carbon-neutral, use only renewable energy sources, and produce zero waste.In the United States, news of the nation’s first fully eco-sustainable city has just been announced. At 41,300 acres and a new SLDI member, Florida’s Destiny is ranked as one of the state’s largest private land acquisitions and will create working greenspace where the ecosystem is integrated into its infrastructure in order to preserve the overall quality of the environment.The problems – and answers – have been known for many years. It will ultimately be the visionary risk-taking land developers, the business structures we organize, the innovative technologies we use, and the quality of services we retain, that will get us there.Your participation and comments are welcome.Terry MockExecutive DirectorSustainable Land Development Internationalwww.SLDI.orgPromoting land development worldwide that balances the needs of people, planet & profit, for today and future generations.