So here we are in a financial crisis

Aaah, Armageddon. It's a strange day when you think for the first time that you are witnessing a moment whose handling will determine the course of history. Stuff the great grandkids might have to revise for their exams. The financial crisis is turning out to be a lot more than that : an economic but also a moral one. Sarkozy said while he was presidential candidate that international capitalism needed to be moralised, and it seems that it is not only desirable but crucial if the system is not to implode. So what are the causes of and the reactions to this shit creek situation?

As usual, it seems easy to blame it on the Americans, but they do rather deserve it. That said, it is impossible to pinpoint a first day of the crisis. Do we refer to the day that world stock markets crashed in historic unison? Or do we creep up the calendar to the symbolic day that Lehmann brothers went bankrupt? Or should it be when subprimes became an everyday word? Do we go further back to the first tremble of butterfly wings a quarter of a century ago when world leaders, led by Thatcher and Raegan, laid the groundwork for the liberalisation of international finance?

I think 9/11 is a good place to start as it was less than a year after the beginning of GWB's first term and smacks of the "before and after". 9/11 was an obvious blow to Amerian morale, and in Economics, a good way to cheer people up is to send them shopping, which also boosts consumption and gives the economy an adrenaline rush, whereas low morale turns the economy sluggish. So when the biggest morale crusher in American history devastated Manhattan, the Fed, or its governor Alan Greenspan, decided to cut interest rates, just as it had after the dotcom crash or Y2K angst. With historically low interest rates it became easier for the average American to borrow money and, more importantly, spend it. In contrast, many European countries had been nagging the independent ECB to significantly cut rates for years, which it didn't. The ECB's main reason for keeping interest rates high was to fight inflation but ultimately its decision might prevent Europe from sinking too far in the quicksand of an economy running on credit.

With lower interest rates (IR) the Americans started spending money they didn't have and, crucially, couldn't afford, courtesy of a banking system that lent money regardless of whether it could ever be paid back. This attitude was tied to the belief that house prices, which had been soaring for years, would continue to do so. Thus, anybody owning or planning to own a house was considered 'safe' as the value of their capital/house would surely increase. With low and sometimes negligible IR, through the irresponsibility of the banks and the property bubble, Americans stocked up on houses and cars and other consumer goods, living off trillions of dollars of credit to finance the American dream.

There was of course a catch to all of this. The IR were not fixed and by 2006 they had soared up. Soon, people who had been paying close to 1% interest on their loans found they had to pay five times that. Monthly repayments exploded. In three years the Fed's IR went from 2% to 5,75%, and the variable interest rates fluctuated accordingly. When repayment was impossible, banks seized the houses and put them on the market. All over America, as "for sale" signs were nailed to porches, the sound of the property bubble popping could be heard. The banks, far from being richer thanks to the sales of the houses, found themselves with a load of properties in a flooded market and they had to sell them for a fraction of their estimated price. They lost huge amounts of money and started going bankrupt. This is the subprime crisis.

So how did this very American problem (because linked to American banks and American loans, culminating in an American property crash) become a world crisis? To understand this, it is crucial to remember how investment portfolios are constituted and the importance of confidence and expectations on the market.

Concerning investment portfolios, while the details may be hideously complicated the general idea is pretty basic. Imagine you are a bank called Rippoff and co. You have lent vast sums of money to people and to show for it you have a load of virtual receipts saying that people owe you money. Like all banks you do not keep these virtual scraps in a vault, rather you chop them up, repackage them and sell them to a bigger or different bank who now "own" the money that Rippoff is owed. The new bank, Fukkem inc, will then do the same. It will take a bit of this and a bit of that and a bit of Rippoff and muddle it all up and sell it on to another bank, Skruya International which is based in 30 different countries and on 5 continents. Do this enough times and by the end it is obvious that nobody has a clue what they are buying and a bank the other side of the world will have a bit of Fukkem, Rippoff and Scruya in it. All they know is that the package, constituted of a million molecules of different companies, is worth roughly this at this time and is expected to increase or decrease in value.These packages are also border-blind and are thus present all over the world.

So all of a sudden, with the property market crash, Fukkem, Rippoff and Skruya find themselves broke (Lehmann Brothers, Fannie Mae, Freddie Mac in the States notably, though the US bailed out the last two.) When that happened, packages in banks droppped in value because of the drop in value of what made them up. This is not the most dire consequence, though. Worse to come was the drop in confidence that led onto the stockmarkets crash seen all around the world, especially in the last couple of weeks.

Banks do not have a pile of banknotes locked in the cellar, and when you take out a loan they do not go to a backroom and peel off a sheaf of them. Most of this money is virtual. For example, in France, if someone wants a hundred euro loan, the bank need only have nine euros of its own. So imagine a bank (Arssfuk ltd) has 27 euros in the kitty and has granted three 100 euro loans : it can't give anymore. The way around this is the interbank lending system. Arssfuk borrows money from Sookmidic Bank and in return Soomidic's guarantee is, yup, in those little packages which contain bits of Rippoff, Fukem and Skruya. Or not. That's the problem, paranoia takes over and the banks no longer want to lend. This is the liquidity crisis. If everybody were to panic and run to the banks with an empty suitcase asking for their savings, there would not be enough in any of them. This is why leaders are saying DO NOT PANIC!!!!! And why the Central banks are pouring money into the system and/or promising to guarantee the loans, ie, if a bank can't pay back its loans the State will step in.

So banks no longer want to lend to each other, each thinking that the next is going to land them with a worthless package contaminated with bankrupt bank components. As a result, banks must be more careful with the loans they give (not necessarily a bad thing). This has however gone to extremes, where even small profitable companies now have difficulty borrowing money for investment, which is ultimately disasterous for the economy, giving lower growth and higher unemployment among others.

The most spectacular aspect of the crisis for most people has been the drop on the world's stockmarkets, sometimes double figure drops or close to them. This is due to the lack of confidence on the stock market which translates as people either selling wildly or reluctant to buy or a combination of both. Thus shares in France for example in some companies such as Renault or St Gobain fell by over 70%. This is the stockmarket crash which shows that despite money pouring in to the system from the Central banks investors are wary and specualtors less enthusiastic.

So what responses have there been on an international level?

There have been two interesting reactions (many more, but not in this post), one from the Amricans, the other rom the Europeans, and most notably the British. Sarkozy, much as I hate to admit, deserves a medal.

In America the Paulson plan aimed to simply buy back, for a trifling 800 billion dollars, the dodgy loans. This is intervention on an incredible scale and for the socialists among us, a certain amount of glee is felt, these people having aid for yars that the market "regulates itself" and does not need any kind of State intervention (which is true, if you don't mind a few million Americans becoming homeless). Any presidential candidate who promises even consiudering a tax cut in the future is either mad or lying.

In Europe, Gordon Brown made jaws drop. After the Thatcher/Major years where pretty much everything except the State was privatised, and after the Blair/Brown years where England produced an economic miracle based on the deregulated financial sector, first Northern Rock was nationalised, and in the last few days the State has become the main shareholder in eight major banks. Sarkozy, currently head of the EU, organised a meeting with all European leaders (no small feat) and has suggested the same on a continent wide basis. Despite (notably) Ireland and Germany's reluctance to participate in EU-wide measures, Sarkozy is somehow holding it all together. All European countries are now buying shares in the biggest banks and are thus guaranteeing any dodgy loans by pledging to bailout any lenders that default.

In France specifically, Sarkozy is producing 360billion euros to save the situation, including €320 billion in guarantees for new bank debt and a €40 billion fund for recapitalizing lenders. In exchange the State wants to have its say on how the banks are run and how bankers are paid, which is not unreasonable given the circumstances. Moreover, this will not be free for th banks who will have to pay interest. The blurb from the government is that this will not cost the taxpayer anything as a) the banks have to pay interest and b) the banks will be privatised again ASAP. Of course this is only true if the situation gets better. If not, the State will bail out and citizens get the bill.

In the next few days, Sarkozy and others are meeting Bush (god!!! why him?!) for the second "Bretton woods" this century. What lust come out of it is a complete upheaval and, yes, even if th word has been overused, moralisation of the international financial system. In the meantime I suggest you invest in gold.