How the credit crisis came about can be explained in a straightforward way – getting out of the mess is another matter. Here’s what we know so far…
There is a quite famous economist by the name of Paul Krugman, once at Massachusetts Institute of Technology and now at Princeton, and a columnist with the New York Times.
In one of his books he tells the story about a babysitting club that he and some other academic friends started up when he was a young underpaid academic. The club worked on the basis that everyone had credits issued at the start and they could use those credits by giving them to other members of the club who offered to baby sit.
So, let us say, each of us has 10 credits for 10 nights of babysitting. I want to go out one night and so I give one of my credits to another member of the club who then has 11 and I have nine. The theory was that everyone over a period would spend their credits and everyone would end up with roughly the same number of credits and the thing would keep going on and on.
After a while, everyone did have the same number of credits but the reason was that no one wanted to use them. Rather, they were hoping that someone would ask them to babysit and they would increase their number of credits. In the end, the credits were worthless because no one wanted to surrender their credits. The “market” froze.
That is what is happening today. It has nothing to do with sub-prime mortgages (although they triggered the tsunami). It has everything to do with people with money not wanting to share it around by lending and getting it back again.
Banks that have money don’t want to lend it to other banks for fear that the other bank will keep it and not give it back again. So, what do people and banks do with their money? They lend it to the US Treasury on short-term deposits, which is like pooling all the babysitting credits and not using them. Markets freeze.
So, then what happens? People in the street are worried that things will become terrible and so rather than exchanging their credits or money with shopkeepers, they either put the money in a bank, which they believe to be safe and insured by the US Government, or they lend it direct to the Government and it goes into the same hole and the market freezes.
In fact, since this thing became really serious, the savings of people in the street have gone up sharply, which means less money going around, less production, less jobs and… you guessed it: recession, because everyone is storing up their credits.
However, something more sinister is lurking behind the scenes and once again, you guessed it! There they are, the guys in the pin-striped suits, perhaps these days with the casualness of a tie-less Armani shirt. What they have done is tucked away in the banks vault a lot of “people” credits, called mortgages.
There are two reasons they have hidden them. The first is that they aren’t worth what they paid for them. It is a bit like a member of the babysitting club taking a credit from another member and keeping it but not turning up to baby sit. They say “look, I will make it up to you and I will give you two babysitting nights the next time”.
However, the member who has been jilted doesn’t trust that member anymore and stores his or her credit in a drawer in the bedroom. Everyone hears about this jilting and so no one trusts one another and so everyone else stores their credits in drawers in their bedroom for fear if they give one up, they will not get it back again. No one is prepared to trust one another and so the credits become worthless.
So, these pin-stripe suited guys who have these bundles of mortgages over properties that aren’t now worth what they paid for them realise that no one will deal with them with these mortgages (credits) on their books for fear that they won’t be able to return the favour. Suddenly, with these mortgages tucked away in the vault of the bank because no one wants them; the market freezes.
Another thing that happened was that the accountants and politicians got together some years ago and said that every company had to disclose in its balance sheets, the true market value of all of their assets.
Hell! The guys with the open neck Armani shirts rushed to the vault and counted all these pieces of paper that no one wanted and realised that because of what the accountants and politicians had done, these pieces of paper had no value.
So, every bank that dealt with one another in the past, like members of the babysitting club, suddenly got frightened that if they gave a credit to one of their mates who were holding these pieces of paper in their vaults, they might screw them and so decided not to give them credits (or lend them money), and so the markets froze.
Then TED came along. TED had been a silent observer of all that was going on and kept a record of the number of credits that were being exchanged and whether everyone was playing the game fairly. Every now and then TED realised that they weren’t and recorded this fact in a graph called the TED spread which disclosed that every now and again, when banks played up, the banks demanded more credits for an exchange of money than was normally the case.
Suddenly, when everyone discovered that banks had buried their credits in a vault and no one wanted them and when banks that did have money put it in the hole of the US Treasury, the only way banks with money could be persuaded to lend some of that money to one of their “mates” was to charge an interest rate that TED recorded as being so far over the market as to frighten people off borrowing, and so credits stopped flowing and the market froze.
Everyone now consults TED only to find that each day, in fact, each hour, TED is recording that if people want credits by way of loans, they have to surrender a lot more than they are getting – and each day, TED’s score is going up and the market is freezing because it looks at TED’s record.
So, what do people do for credits? They hunt around for anything they can find and sell it at fire-sale or below fire-sale prices. Everyone wants to sell and the only people who want to buy are those who have been storing some worthwhile credits like cash.
They part with the cash and get something that is worth a lot more than they are paying for it and put that in the garage. The people who get the cash use it either to pay a deposit on what they owe or they put it in the hole of Uncle Sam’s treasury vault. There is no movement of credits and so the market freezes.
How on earth do you stop people with credits (money) putting it in a hole? How do you get them to put it back in the market place so that people start exchanging credits again?
That is where we are at the moment. From everything I have seen, I believe that the steps that have been taken should work.
What we need at the moment is someone to step in and tell people that it is OK for them to start swapping credits again. The trouble is that there is no one around at the moment who people believe.
Accordingly, we can do what we like so far as policy solutions are concerned, but if there is no one in the babysitting club who is trusted, then we have to worry about what happens when the patient runs out of oxygen and ends up with credits that no one will touch because they fear that they will not buy oxygen.
What is missing in all of this is leadership that can be trusted. No one will listen to economists or bankers because they are perceived to have got us into this mess. The current President of the United States has lost all political capital and is trusted by only 22% of the American population and has an even lower credibility rating in other countries.
Who else is on the stage at the moment who can stand up and say “trust me; what we have done is going to work”. If you can think of someone on the scene at the moment who can do that, let us hear about it because what the world desperately needs at the moment is leadership that is trusted, otherwise no one will swap their credits.
Louis Coutts left law and became a successful entrepreneur. His blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Click here to find out more.
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James Dean writes: Trust is broken and as such needs to be earned back by repetitive trustworthy behaviour or by someone vouching for the untrustworthy entities.