January 28, 2008 | posted by Michael Baxter in credit crunch |

If there is one lesson to be learned from the crisis currently doing the rounds, it is that one set of problems often creates another set.

It’s a little like the domino theory – which once dominated the thinking behind US foreign policy. If one country falls to communism, went the theory, then the country next door might fall. How wrong the theory was when applied to US paranoia over the threat from reds under the bed, but maybe for the economy, this idea has more legs.

In the article above, the story of the East Asia, Russian and LTCM crises was told. Each problem seemed to set off the next. Earlier this decade, the dotcom crash led to a wider stock market crash, which led to the emergence of problems at WorldCom and Enron.

In John Kenneth Galbraith’s seminal book, ‘The great crash of 1929’, a catalogue of disasters was revealed, and bad practice, risky investment strategies, for long hidden because things were so good, unwound.

The formation of bubbles always seems to create more greed. As more and more people want to benefit from the booming market, the longer the boom lasts, the more risk seems to be forgotten.

Actually, right now, we are seeing a big rift emerge between central bankers in the US and Europe. As Ben Bernanke pumps in more money and slashes interest rates, Mervyn King talks about reassessment of risk, something he seems to think is vital.

Earlier this month, KPMG said, “An economic slowdown in 2008 as the result of the credit crunch could result in a rise in the emergence of high-value corporate frauds.”

Last week, Nick Leeson was reeled out as an expert and no doubt, Ewan Macgregor wondered if he could do a passable Jérôme Kerviel impersonation, as the story of Société Générale was unravelled.

The sense of déjà vu with Barings and Leeson is extraordinary – although things could have been a lot worse. Total losses at the bank relating to the saga were £3.7bn, but the bank’s total exposure was nearer £37bn, equivalent to around the total value of assets at the bank.

But, even while we were still shaking our heads, the FT has warned that some holders of derivatives actually want some companies to fail. The FT cited research from academics Henry Hu and Bernard Black and said, “According to the research and industry practitioners, creditors have a strong interest in voting against a restructuring plan if they have bought credit or loan default swaps, which trigger payments when a company fails.”

Warren Buffett once described derivatives as financial weapons of mass destruction – you can see why.

Meanwhile, this morning, the BBC reported how one banker at Davos said, “The consumer credit market will be the next domino to fall after sub-prime mortgages.”

In his book, Galbraith said “To the economist, embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss.”

It seems though, that today, it is not just embezzlement, but we can add fraud, a stunning level of irrational exuberance from money lenders, and who knows what else has been bubbling beneath the surface, and only now is coming to the fore.

No wonder George Soros says markets don’t always work. And yet, in the US, Bernanke, by effectively dropping money from his fleet of helicopters, is dealing solely with the symptoms, and ignoring the underlying problems.