September 16, 2008 | posted by Michael Baxter in Banking, credit crunch |

Imagine what a shock it must be for the ostrich that removes its head from the sand. One can imagine its serenity turn to panic, and its demeanour turn from that of an all-too-cool bird, to something akin to a headless chicken, blinded by the bright light of reality.

That is what happened yesterday. On an optimistic/pessimistic scale of one to ten, with ten representing pure optimism about the economy, and one pure pessimism, this column has probably been around level three – expressing considerable pessimism about the economy in the short-term, although much more positive about the longer-term prospects. Markets have got it wrong over and over again. Inexplicably the Dow hit an all-time high last October – after the credit crunch had begun. Throughout this year, the slightest whiff of good news, or even news that was really bad but superficially looked good, saw markets soaring. Last week, when the US government took the unprecedented step of nationalising Fannie and Freddie, markets soared and we were told the worst was now over.

When Alistair Darling talked about the worst conditions in 60 years, he was ridiculed.

The markets, many of the world’s economists and commentators had their heads so firmly buried in the ground that they could not see reality, and totally failed to judge the seriousness of the current crisis.

Yesterday, their eyes were removed from the ground after months in the dark; they were left blinking and shielding their vision from the unbearable light, and they panicked.

For months they failed to call the seriousness of this crisis. Yesterday, they went the other way. All of a sudden the media is talking about meltdown, about how no bank is safe, the impending and systematic collapse of the financial system. Once again, they have got it wrong. They have overreacted.

Consider the dotcom bust. One moment dotcoms were the greatest thing since sliced bread, and probably a great deal greater even than that. The next moment, any internet business was hailed as a disaster. Forward wind the clock eight years or so on, and the reality is at last striking home. The internet really is hugely important technology, perhaps the single most important innovation since the printing press, and its impact on the global economy is only just beginning. The markets totally failed to understand the internet, and its significance. They jumped in too fast, funded businesses based on the most dodgy of plans, then because these no-hopers proved to represent a bad investment, turned on the internet, like a child on its one favourite toy. 

And yesterday we saw a familiar pattern.

That is not in any way to understate the seriousness of the financial crisis. The collapse of Lehman, the troubles afflicting AIG and the hasty sale of Merrill Lynch all confirm something that those whose heads weren’t buried in the ground understood all along.

But this does not mean the end of Barclays, or HBOS. It does not mean the mattress is the only safe place to store our money.

The US Treasury, and its top man, Hank Paulson, who remember is the former boss of Goldman Sachs, made a calculated decision in letting Lehman go.

You have to have some sympathy with its staff. The bank’s mistake was not that it was incompetent, it was that it wasn’t incompetent enough. It made massive errors, but these mistakes were not on the scale seen at Bear Stearns. If it had failed at the beginning of this year, it would have been rescued.

But that was before the banks had been given time to digest the full implications of the credit crunch; it was before the Fed had taken many of its drastic steps to restore liquidity. Mr Paulson figured that the failure of Bear Stearns would have been catastrophic. Lehman Brothers’ collapse, on the other hand, he reasoned would not bring the financial industry down with it.

It’s those two words, moral hazard, that remain the key. Bail out a bank, it doesn’t learn its lesson. For decades, banks have been saved. Alan Greenspan steered the US economy free of serious recession for years, but he did this by bailing out the system every time it hit a problem.

But the electorate are fed up with it. Those who vote in governments are fed up with seeing this regular cycle of banks’ exuberance leading to crash. They reason that they are not learning their lesson.

Evolution favours those who are best adapted to survive. For decades, governments have made the forces of natural selection, when applied to the finance sector, impotent.

Yet this morning, on the Today programme, one commentator ventured the view that politicians were pandering to the whim of their voters. Bankers are never popular. When they receive six-, or even seven-, figure bonuses, public sympathy evaporates. In this environment of envy, it is argued the public want to see the banks punished, without understanding the implications of this.

Yesterday evening, on BBC2 Newsnight, Anatole Kaletsky was scathing of Hank Paulson’s decision not to bail out Lehman Brothers. He drew a parallel with Andrew Mellon, US Treasury Secretary in 1929, who was happy to see banks liquidated. Mr Kaletsky argued that the real villains are the hedge funds, that it is they who have created the problems for Lehman.

He argued that it is the banks with long-term plans, who are looking ahead, who are suffering. The hedge funds, pre-occupied with the short-term, are creating problems, and that the government should have saved Lehman from these scoundrels.

Furthermore, goes the argument, it should have supported Fannie Mae and Freddie Mac, lent them money rather than nationalise them.

But at heart, the crisis we are seeing is down to one key error.

The error relates to house prices – the view that they always go up, and any loan secured on a property is safe, because the property will always be worth more than the loan.

This is the true lesson of this crisis. The complexity of the bank’s financial dealings has hidden this truth.

The solution to this crisis lies in the speed with which markets adjust.

The mistake made in Japan ten or so years ago was denial.

History tells us that markets only tend to turn when just about everyone has given up on them.

Right now we may be seeing that moment.

And one piece of news developed yesterday; it hardly showed up on most media’s radar, but in some ways it is just as significant. To find out what that is, read the next article.