We've moved from a world of risk to a world of uncertainty -
BY THOMAS HOMER-DIXON -
From Wednesday's Globe and Mail -
March 19, 2008 at 6:56 AM EDT -
The U.S. central bank is sla****ng 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 op****tunities 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 re*****s 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.
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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"
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