Globally, credit has been growing at an unsustainable rate for 30 years.
This represented, we were told, a "gearing up" of excessively conservative balance sheets, a new phase in the evolution of the great capitalist wealth creation machine.
But on top of an overt gearing up was overlaid complex derivative strategies to spread risks. Packages of dud mortgages and other credit instruments were created and flogged to pension funds, other banks and, presumably, Belgium dentists.
"Pass the parcel" used to be a children's game, but became a far deadlier game played by adults gambling with their shareholders' asset base. It got to the stage that no one knew what was in each package, who owned it or whose balance sheet it was on at any one time.
As a result, suspicion fell on every financial institution, as well as overgeared businesses. Financial institutions responded by declining to trust one another's credit. Loans to overgeared companies were pulled, leaving them to fail or sell assets at firesale prices.
Financial gridlock was relieved spasmodically by the US Fed and other central banks, but now the Fed is getting to the point that its mighty balance sheet is within sight of being exhausted.
The US Treasury Secretary said two weeks ago that the Treasury was not in the business of bailing out imprudent investors. Fine sentiments, but if the problem of gridlocked financial markets is too big for the US Fed and other central banks to handle, the US Treasury will be forced to change its tune or preside over another great depression.
Experts are saying that current problems will not quickly be resolved. What is likely to be the outcome?
The direction of adjustment is clear, but the eventual severity is not.
Directionally, the consequences will include:
There will be a vast de-leveraging of balance sheets. Credit will shrink dramatically and when growth resumes it will be at a far slower rate.
Failed financial institutions will be forced into mergers, as with the takeover at a firesale price of Bear Sterns by JP Morgan. Many formerly highly paid employees of financial institutions will lose their jobs.
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