An Unheard of Crisis of Confidence

What a cold shower!

On Wednesday, October 8th , the seven central banks which make up the European Central Bank lowered their interest rates in order to jump start the economic machine – something which has not been seen since September 11, 2001. It wasn’t enough to stop the downward spiral of stocks. Paris, Frankfort, and London have continued to plummet, the Dow Jones finished down -2.21%. A few hours earlier, “far from all conventional thought or far reaching dogma”, as Gordon Brown commented, the United Kingdom announced the partial nationalization of it’s eight largest banks. It was a wasted effort. The markets remain deaf. And the confidence isn’t there.

The crisis of 2008 has become a crisis of confidence, like the many other systemic crises which have come before. The experts in the resilience of confidence in the economy understand, in part, what is going on. And which is illustrating the peculiar function of markets.

Following the stock market crash of 1987, investors were surveyed to determine the causes of the panic. André Orléan, director of research at CNRS, remembers a list of ten things – high interest rates, alarmist declarations from the American Secretary of the Treasury over the dollar, etc. – which were proposed to have possibly caused the crisis. None held up. The investors, both individuals and institutions, asserted that the fall of 200 points in the Dow at the opening of the markets on October 19, 1987 and the falls in price at the end of the preceding week were to blame for their massive sales. “Market collapses have their own dynamics which inevitably don’t rely on economic reality in the short run”, explains Mr. Orléan. It is the beauty contest explained by Keynes: the real value of assets counts less than the representation that the market posts as fact.

Many other points – imitative behavior, uncertainty of present and future values of assets, etc. – are proposed by economists. “You must remember”, insists Jean-Paul Pollin, professor of economics at the university of Orleans, “is that the actors in the financial markets do not necessarily act… according to the logic of the market.” The American economists Douglas Diamond and Philip Dybwig, recounts Dr. Pollin, analyzed, at the debut of the 1980’s, cases of bank panics. If one makes a deposit at his bank, it is because he thinks that he will be guaranteed liquidity. But if he sees that others are removing their money, he will want to do the same. It is not absurd conduct, on the contrary, the depositor thinks that there is a sufficient number of irrational men to menace the reliability of his bank, though their reasons might be wrong.

Even though the current crisis resembles those of 1929, 1987, or the collapse of the Internet bubble in 2001, the mechanism of the loss of confidence is different in two ways: the novelty and the complexity of the assets which have caused the loss, and its global scope.

No economist isn’t attempting to clarify why those assets have become “rotten”, which are at the heart of the stock panic, and to which no one dares set a value, and will have been purged. There is no consensus-however essential to confidence- between the actors on the market to fix the real value of the products which they hold in their portfolios. “We’re paying the price of the financial innovations (of derivatives and structures) which developed during the 1990’s”, explains Mr. Orléan. “And we are witnessing their crisis for the first time.”

Asymmetry of information

How does one get out, for example, of the trap of Credit Default Swaps (contracts to exchange the risk of default)? These are in principle insurance, where one pays to become insured…. against the risk of a third party. The economist Paul Jorion evaluates the American CDS market at 62 trillion dollars, a figure close to the total of all banking deposits worldwide. “When one thinks”, explains Peirre Cahuc, professor of economy at the Ecole Polytechnique, “that certain financial establishments propose to their clients assets the descriptions of which fill a manual of 150 pages, one better understands why the interbank market is frozen. No one trusts anyone.” In technical terms, this is called an asymmetry of information, which was described by George Akerlof, Joseph Stiglitz and Michael Spence (the three won the Nobel Prize in economics in 2001) in the used car market. This is where the buyer always wonders if the vendor is lying to him about the real value of the vehicle. But, for all economists, the asymmetry of information which is rife among the financial markets is one of unrivaled proportion.

The second point which explains why confidence is so thin and so difficult to reestablish is this: the global character of the crisis. If many of the falls in the past had their global effects, none effected as many states as simultaneously as this one. The United States, Europe, and emergent countries… each is asking questions about the possible failure of banks, of Indonesian, Russian, Korean, Brazilian. And this is not without consequence. Because if the world markets spontaneously coordinate their distrust, there exists no international authority whose legitimacy is broad enough to permit it to restore confidence. The United States no longer has this power, especially not now during the few weeks until their elections, while their political economics have been knocked off balance; Europe has shown her disagreements and the International Monetary Fund(IMF) doesn’t have the means. The times when a single country can reassure the markets through it’s own action during a crisis are over. The area of crises are a new frontier. The times of Raymond Poincaire and Antoine Pinay are over.

With the October 8th concerted drop in rates, the Europeans, Swiss, Canadians, Americans, Swedes, English, and the Chinese have shown that global cooperation is possible. This is indispensable to restore confidence in the system and get it going again, around the world.