Share prices fell sharply on international stock exchanges yesterday, with the Irish stock market recording a fall of 3.8 per cent. The overall index of Irish share prices has now declined by almost one-fifth from the peak it reached in February this year.
Uncertainty is at the heart of the stock market slump of recent weeks. Uncertainty differs from risk. Risks can be reduced to probabilities and quantified as a result. The chances of living to a certain age can be calculated actuarially. Once estimated, a risk can be insured. The insurance industry is built upon the principle that it is possible to insure against the occurrence of a specific event. Uncertainty cannot be reduced to risk. It is unquantifiable and cannot be insured or hedged. No one knows the outcome. This, in essence, is the problem faced by financial markets at present. Visibility is extremely poor.
Money became very cheap internationally after 2000. By mid-2003, core interest rates in the US and the euro zone stood at 1 and 2 per cent respectively. When confidence is high, steep reductions in the cost of money will usually trigger a boom in asset prices. The performance of the Irish housing market over the past decade proves the point. Against this background, a number of financial institutions in the US proffered mortgages to individuals with poor credit histories. Subsequently, US interest rates climbed back to 5.25 per cent. As a result, many of the so-called "sub-prime" mortgage borrowers cannot now afford to meet their mortgage obligations.
In the past, widespread mortgage defaults would have caused serious difficulties for the lenders concerned, but the problems would have been specific and local. Now, because of the internationalisation of money, they are general and global. For the mortgage lenders in the US repackaged the mortgages they had provided so irresponsibly and sold them on as assets, often to financial institutions overseas. In turn, many of the buyers borrowed on the strength of these putative assets in order to finance further, highly-leveraged, purchases of their own.
Uncertainty in financial markets is now verging on the hysterical because no one knows which financial institutions bought the spurious assets and which institutions have used them as collateral to raise additional loans. Financial institutions are becoming increasingly nervous about extending credit, as available information is insufficient to segment the good credit risk from the bad. The underlying uncertainty may take months to resolve. But this is essentially a problem for financial markets and must be solved within those markets. The task of the monetary authorities is to ensure the problem does not spill into the real economy of work and enterprise.
In an effort to calm nerves and relieve the excessive tightening of credit, the European Central Bank over the past week has pumped cash into European money markets on a heroic scale. It is to be hoped its efforts ensure that a financial shock does not undermine future growth prospects for the European economy.