The scale of the global financial crisis is still unknown, writes Ray Kinsella. What we do know is that global leadership to deal with it is absent
There have been market collapses on previous occasions, though by any standards the carnage on global equity markets which began on Monday is exceptional.
Markets have adjusted to previous crises - it's what markets do. This time may be different. While the immediate cause of the dramatic falls in market indices appears to be the acknowledgment of a recession in the United States, it comes on the back of a full-blown contagion such as has not been seen before since the breakdown of the international system in the early 1970s.
What is equally disturbing is the panicked response by the US Fed to the collapse.
This point needs to be made: the still evolving sub-prime crisis in the US, has generated unprecedented write-offs by major financial institutions and has induced a quasi-paralysis within and across markets, the full scale of which is still not evident.
What we are observing now is a global problem. What is demonstrably missing is global leadership, commensurate with the scale and nature of the problem.
This is not, it should be said, simply about macroeconomic imbalances. Nor is it about the very real pain and suffering that will be inflicted on individuals and households, as well as on the corporate sector, by a failure of leadership. This is about massive uncertainty, and even fear, in the face of a systemic crisis in global financial markets and a shambolic response on the part of global central bankers and policy makers.
A sense of proportion is always important. In the last two decades, there have been a number of catharses in the global economy and there have, as the European Central Bank has demonstrated, been a succession of individual bank failures.
What confronts us now is something of a different order. The global western markets are under threat from the fundamental flaws in the business model upon which it is based and in the failure to develop a system of global financial governance which matches the explosive growth and pervasive importance of international financial markets.
Following a succession of tremors, this latest shock to the system ranks very high on the Richter scale.
Western mainstream financial institutions are based on a business model aimed at maximising shareholder value (SV). This model subjugates the common good to the interests of the owners of capital. This is a model well past its sell-by date. In a knowledge-based economy capital is no longer the key factor of production. This alone argues against the over-riding priority of the business being to maximise shareholder value. This fallacy has been compounded by the short-termism embedded within the model - the fixation of management, and of the whole organisation, on the next set of quarterly earnings.
The consequences of this mindset should have been obvious from the events of the 1990s and early 2000s, for which Enron stands as the defining metaphor. But the lessons were not learned. Some initiatives - notably international standard-setting in accounting and auditing - were eminently sensible and did not require a prior justification. However, some attempts to fix a terminally flawed model were downright counter-productive - for example, the US Sarbanes Oxley Act (SOX), which is in reality an over-prescriptive form of regulatory imperialism. The term "ethics" was hijacked and pressed into service in various domains across financial market activity, without any evident understanding of what ethics actually involves, especially in regard to respect for the person.
Notwithstanding this, the SV model - an antiquated construct and a time-bomb waiting to detonate - began ticking in the low interest rate environment of the early years of this decade.
The term "sub-prime" is an exotic euphemism for what were high-risk mortgage loans to vulnerable individuals and families. The exponential growth in this market was driven by the insatiable demands of the SV business model to generate more and more earnings, irrespective of developments in the monetary environment and the knock-on impact on the real economy over the median term. The search for yield, for ever higher returns, albeit at the costs of taking on excessive risks, within new exotic and opaque financing structures, contributed to increasing volatility in international financial markets. This reached alarming dimensions by mid-2006.
The more than doubling of interest rates by 2006 provided the inevitable reality check. It precipitated a crisis in the sub-prime market, a collapse in balance-sheet valuations of institutions which had invested in mortgage-backed securities.
This was then transmuted into a generalised crisis of confidence. Institutions in highly interlocked markets finally realised that what they had thought was a very clever game of generating higher returns from dodgy investments was, in effect, more like "pass the parcel" of high-risk illiquid investments. Catastrophic multibillion-dollar losses were recorded by major financial institutions and, within an environment characterised by an erosion of trust, which is central to the functioning of the markets, there was a freezing up of international credit markets.
It should not have happened and the primary reason it actually did happen is that financial institutions and intermediaries remained - notwithstanding the Enron experience - fixated on earnings and profits and levels of compensation, to the exclusion of sustainability and the common good.
In terms of regulation and governance, there was an almost total lack of coherence in the response at a national and global level to the "sub-prime" crisis and to its effects across the markets. This was encapsulated in the reaction by the UK authorities to the near meltdown of the Northern Rock model for funding its mortgage book.
For all that has been written on this event, the single most compelling point is this - there is hardly a single monetary economist in these islands who believed they would witness a full-scale "run" on a major financial institution in a highly monetised society.
Issues of politics, monetary policy and financial stability ebbed and flowed across the corridors of Whitehall, reflecting the fragmentation of regulatory authority. There were problems of co-ordination and alignment of the different objectives of the Treasury, the Bank of England and the Financial Services Authority, as they struggled to respond. The instincts of depositors, who queued, in the teeth of official reassurances, were right - this has severed the umbilical cord of trust on which both markets and regulators depend. It will be even more difficult for the authorities to hold the line next time.
The response of the authorities was belated and reactive. Responsibility for managing the effects of the Northern Rock debacle has passed from the boardroom to the Treasury. It's not clear whether it will be nationalised or sold. The proposals recently announced by the chancellor of the exchequer amount to yet more regulation. The UK experience is a microcosm of the fragmentation of regulation and governance at a global level.
The global credit crunch - of which Northern Rock was a predictable victim - was a manifestation of a contagion: the phenomenon whereby market failure spreads, virus-like within, and across, financial markets. It is what keeps central bankers awake at night. It was the prospect of contagion which prompted the intervention, in September 2007, by the US Fed, the Central Bank of Canada, the Bank of England and the ECB. Acting as de-facto lenders of last resort to global (basically western) financial markets, they signalled their willingness to make available funds to the credit markets against a wide range of collateral (some of which had been infected by the sub-prime crisis) at non-penal rates.
This intervention came late in the day and merely papered over cracks. There is no evidence that the key lesson of the near-collapse of Long Term Capital Management (LTCM) in 1998 had been learned. LTCM and the contagion which it threatened to unleash were stopped in its tracks only by the purely fortuitous and courageous intervention by the former president of the New York Fed. This is not the NY Fed's job.
There is no one in charge in the event of a future full-blown crisis in global financial markets - not the IMF, not the Bank for International Settlements, not the OECD, not the ECB. Attempting to co-ordinate a set of regulators in enormously large and complex financial markets is a wholly inadequate response to the very real prospect of future contagion. This co-ordination problem will become progressively greater, not alone because of, for example, the prospectively greater role of China in the international financial system, but also because technological innovation will leave central banks behind.
The problem does not lie in markets or money or in profits: it lies in the idolatry of markets which is at the heart of western mainstream finance and which, in reality, serves only to subvert and skew the operation of markets. The SV business model has, effectively, separated markets from their constitutive purpose of enhancing economic efficiency and thereby promoting the common good.
There are alternative paradigms. The principles of Islamic finance provide one pointer. The Judaeo-Christian ethos provides the most sensible guidance to ethical business behaviour within highly monetised market-based institutions.
If - more likely when - a structural faultline opens up across western financial markets as a consequence of this business model, it may well prove impossible to contain the effects in the absence of a single, global monetary authority whose mandate and capabilities are aligned with the scale and complexity of financial markets. This will, almost inevitably, precipitate the transition to a new paradigm which will be traumatic and costly.
We need to begin a debate on moving to a new business model, governed by a sustainable ethos which transcends a purely prescriptive regulatory regime. The EU, and specifically the ECB, has no greater priority than leading such a debate and, at a global level pressing for a fundamental reform of the BIS/IMF into a genuinely global central bank.
Prof Ray Kinsella was formerly an economist with the Central Bank and is on the faculty of the UCD Smurfit School of Business. He is editor of Internal Controls in Banking (Wiley International and Oak Tree Press)