The only way to prevent a financial crisis is for regulators to step in when the party is at its height. But the removal of the punch bowl would draw howls of rage from the partygoers, convinced that good times go on forever.
And the political fallout would be huge. This regulators’ dilemma was discussed at a conference hosted by the Reserve Bank last week.
Speaking from a banker’s perspective, the former chief executive of Citigroup, Chuck Prince, made the same point in July 2007. He told the Financial Times: “As long as the music is playing, you’ve got to get up and dance.”
He was being quizzed about his bank’s lending policy at a time when the subprime crisis was starting to unfold. Defaults in the US subprime (low-income) housing market had already sent out danger signals, which Prince chose to ignore.
In November 2007, Prince stepped down as chief executive and the next January the bank posted a loss of $9.3 billion (R76bn at the time) in the fourth quarter of 2007.
The month after Prince’s comment, which has gone down in the annals of “infamous quotes”, the scale of the approaching disaster began to emerge. The biggest bank in France, BNP Paribas, was forced to freeze the assets of three of its funds, which were based on dodgy paper. No one was prepared to trade in them, making it impossible for the bank to put a price on the securities.
In the weeks that followed, Europe faced a massive credit squeeze as banks refused to lend to each other in case of default and only emergency action from the European Central Bank and other central banks prevented a financial implosion.
In retrospect, 2007 was a year of denial as the main players attempted not to confront the facts.
Speaking at the Reserve Bank’s conference, Charles Goodheart, a professor at the London School of Economics, made that point. He recalled that, in 2007, about six months before Northern Rock faced a run by depositors, the British bank was considered well capitalised.
In September Northern Rock was rescued by the Bank of England and the following year it was taken over by the UK government.
Despite the lessons learnt during the crisis, speakers at the conference said future crises could not be avoided. Whatever moves are taken to stabilise the system, something unexpected always happens to subvert them. The best strategy, they concluded, was to decide what moves to make when the crisis occurred.
Bubbles are built on perceptions of value. Nothing is inherently valuable; value is determined by the context.
When investors are in manic mode any piece of paper purporting to have financial value seems desirable. At the other end of the reality spectrum, a glass of water is priceless in a desert and a tin of banked beans in a famine.
This is a concept that is difficult for gold bugs to come to terms with, especially with the gold bubble apparently endlessly running on. The reason for its long run up is that currencies are increasingly becoming valueless as governments effectively print money. So, yes, gold is relatively valuable, but only because people think it is a store of value. “Relatively” and “think” are the key words.
But gold’s inherent value depends on demand for jewellery and a few industrial uses. Its price, however, price is based on perceptions that it is a store of value – for no better reason than the fact that it is virtually indestructible and looks pretty.