How Did This Economic Crisis Start?

We have learned here at Financial Elite that "This has happened before and it will happen again." History repeats itself and we should all learn from our mistakes.Or do we?

(Money Magazine)Paul Lim, Money Magazine senior editor, interviewed Harvard historian Niall Ferguson. Ferguson argues that financial crises are inevitable- and that some radical thinking will be needed to get us out of this one.

So what does history teach us about this crisis- and how we'll come out of it? Ferguson shared his thoughts with Money senior editor Paul Lim.

What was the toot of this crisis? Was it the housing meltdown, a lack of regulation, too much cheap money?

The origins lie in globalization itself. You couldn't really imagine the credit bubble or the housing bubble of 2001 to 2007 taking place without the great flow of cheap capital from Asia to the U.S., which financed U.S. deficit spending. This was also a story of innovation. Financial history is an evolutionary story. And we saw a great flourishing of new financial species in the conditions made possible by globalization.

How do you see the financial markets evolving from this point on?

When Planet Finance reached the size it had reached in 2007, when he derivatives market was vastly larger than the output of the planet, it was clear that we were on the verge of a natural selection clear out. The species that flourished in this recent era of leverage-when you could wager 50 to 1 if you were a bank- will look like a dinosaur after the meteors hit the earth.

So the era of massive financial conglomerates is coming to an end?

Absolutely. While we will prevent the great dinosaurs like Citigroup and Bank of America from dying, they are never going to be able to operate the way they did.

How come so few foresaw this crisis?

Plenty of intelligent observers did. But market actors failed to heed the warnings. Part of the problem was that incentives for executives and investors discouraged them from taking heed.

Also, a crisis of this magnitude is so rare that it's beyond most people's experience. Only somebody who studies financial history could say, as I was trying to say,"Look, something as big as as the liquidity crisis of 1914 or as big as the banking crisis of 1931 is imminent." Most people have a career memory of 25 years at most. If you want to understand hoe globalization worked-and failed- in the past, you need to go back not years but 100 years.

Isn't the government attempting to go back nearly 100 years now, trying to jump start the economy through spending as it did in the Great Depression?

The economy of the 1930's, when the New deal began, was basically a closed economy. The protectionist barriers were so high that the U.S. could increase government expenditures and have the demand ring just around the domestic worlds. We're not in that situation now. You just can't stop people spending an increment of their income on Chinese imports. So I don't think the stimulus is going to yield anything like the kind of addition to employment or GDP that the government is assuming.

Still, doesn't something need to be done?

Yes, but you can't have the U.S. run a $2 trillion deficit and expect foreign investors to finance it in the midst of massive contraction of trade. Let's assume the federal deficit grows to 14% or 15% of GDP. That's a number we haven't seen since World War II.

This is why I prefer more radical solutions to reduce private sector debt. You need to stabilize the real estate market. As long as property prices are falling at an annual rate of 19%, you can't stabilize bank balance sheets. The assets they're linked to keep becoming worth less.


Isn't Obama's housing plan aimed at reducing private debt?

It doesn't go far enough. The plan is to use $75 billion to incentivize lenders to reduce monthly payments. There Will also be an opportunity fro Fannie Mae and Freddie Mac backed mortgages to be refinanced. to be effective, a large scale restructuring of household indebtedness would need to be mandatory.

So lenders should be forced to renegotiate?

I'd be trying to think about how to effectively convert mortgages nationwide into 20 or 30 year debt at, say, 3%.

Has anything like that been done before?

Yes. It was a frequent occurrence in the 19th century. Governments that were paying 6% on bonds would say, "Look, circumstances have changed. From now on you get 3%." What's different today is that these are private debts, not public debts, and that entails a lot more complexity.

Wouldn't a cram down like that make credit markets more volatile?

We don't really have a great many options here. If we stay the present course, you're going to see the tailspin continue.

Is a depression possible?

It is. The Great depression was initially a U.S. financial crisis. But what made it a depression was its global contagion, and then the breakdown of trade and the retreat into protectionism. All of that can happen. All of that is in fact happening with terrifying speed. Countries have started to use protectionism language, whether it's "Buy American" or "British jobs for British workers."

Do investors need to change the way they think?

Paradoxically, this American crisis makes the U.S. seem like a more attractive place to invest-including for foreigners. America's "safe haven" tag is an important one.

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