Why did no one see the credit crunch coming?

The Queen's tough question about the credit crunch has not been answered
Why did no one see the credit crunch coming? That was the awkward question Her Majesty the Queen asked on a visit to the London School of Economics last year.

By Peter Spencer
Last Updated: 9:32PM GMT 22 Feb 2009

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It would make a useful addition to many economics and finance examination papers this summer.

I would argue that it was hard to predict simply because nothing like this has ever happened before. History is littered with financial crises, but the collapse of the market in liquidity that lies at the heart of this problem is almost without precedent. The only case I am aware of is the collapse in international trade finance that took place after the assassination of the Archduke Ferdinand in Sarajevo, in the run up to the First World War.

The roots of this collapse lie in the global imbalances that have been building up for decades, making the world economy increasingly vulnerable. Huge savings in Asia depressed world interest and inflation rates and were channelled through the US banking system to western borrowers, reinforced since the millennium by the flow of petrodollars.

That helped drive the boom in UK mortgage and housing markets and the fall in the saving ratio. In 2006 our mortgage lenders were handing out £10bn of mortgages every month – and only getting in £5bn of that from savers. The rest was coming in from overseas banks.

The result was an overseas debt of £740bn between 2000 and 2006 – worth more than half of our gross domestic product – typically with a very short maturity. These dollar inflows had to be converted into sterling, which is why the exchange rate was so strong and exports so weak.

I think we all knew it could not last. It didn't matter whether you looked at the global imbalances; the level of house prices, or the 125pc mortgages that lenders were blithely handing out: this was clearly unsustainable.

People had been predicting a sticky end for years, but the dance just went on and on. Gordon Brown was repeatedly warned of the risk we were running with high levels of borrowing by the OECD, the IMF and other institutions. However, the music was so loud he could not hear.

He was not the only one. The Bank for International Settlements clearly warned of the threat to the global financial system posed by financial engineering and high levels of leverage. However, the markets refused to listen and just carried on dancing.

When it finally came, the end of the credit boom was much more sudden than anyone imagined. Like myself, most economists thought in terms of a gradual rebalancing as the debts built up and house prices became unaffordable, with the brakes applied gently. We expected things to turn round gradually, moving in a cyclical way rather than screeching to a halt. The surprise was that this time the international banking markets simply froze, suddenly halting the inflows into sterling and the credit markets. So what we got was more like a car crash. The economy had to adjust suddenly rather than, as we thought, gradually

Regrettably, very few were wearing seat belts. Now all of those heavy short term debts have to be repaid. Northern Rock was of course the first casualty, and the housing market quickly followed, dragging the rest of the economy into recession. The pound has been another casualty.

As I say, economists usually expect things to turn round gradually rather than abruptly. Financial markets can turn on a sixpence, but they usually remain open for business, even after a stock market crash. As Hyman Minsky observed, credit markets swing from elation and speculation to panic and contraction. But they have not shut down before, at least in peacetime.

Interest rates and financial prices can react violently in a crisis, but usually they manage to get demand back into line with supply. If confidence collapses it may take a big fall in the stock market to tempt bargain hunters back in, but eventually this happens.

Credit markets seem easier to understand than the stock market but are actually much more complex. If the supply of bank finance is cut, interest rates will normally rise to help bring demand into line with supply. But as Joseph Stiglitz pointed out in a famous paper with Andrew Weiss in 1981, this will discourage prudent borrowers who tend to be price sensitive, increasing the proportion of bad risks on the loan book. It is hard to prevent this: bank managers can't really distinguish the bad risks; otherwise they would not get a loan in the first place. Credit risk rises, particularly if a recession results, meaning that a rise in the loan rate can actually reduce the profitability of the loan book.

In this situation, banks tend to ration their customers rather than raising rates any further. A similar effect seems to have shut down the inter-bank and other wholesale credit markets in August 2007. Inter-bank rates naturally moved up as the market began to worry about bank losses on sub-prime loans.

But they reached a point at which they began to raise questions about the borrower's ability to repay. Any bank that was prepared to pay 1pc or so over the odds clearly had a liquidity problem. It might also have a solvency problem, especially if it was relying on high cost wholesale funds to fund a historic portfolio of low cost mortgages. So any banks that did have surplus cash simply hoarded it rather than risking it.

Of course there was more to it than that. Once Northern Rock failed, it became clear that wholesale depositors could not rely on the bank regulators to monitor the banks properly.

This also raised doubts about the Bank of England's ability to help out banks without stigmatising them, even if they just had a temporary problem with their liquidity.

Moreover, when the credit markets dried up it was no longer possible to place a market value on many of the banks assets. But whatever the reasons for this, the banks simply stopped lending to each other. Then they stopped lending to us.

Peter Spencer is Professor of Economics and Finance, University of York and Economic Adviser, Ernst & Young ITEM Club

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