Peter Levin’s Rethinking Markets

April 24, 2008

What would a system collapse look like?

Filed under: Markets — Peter @ 8:55 am

A blurb-y article from Thompson Financial (in Forbes online) cites a common feeling among the financial movers and shakers about the current and most recent credit crunch:

The international financial system was close to the brink in March when joint action by the U.S. Federal Reserve and JP Morgan Chase & Co. avoided the collapse of investment bank Bear Stearns, Credit Suisse Group’s ex-CEO Oswald Gruebel said.

The breakdown of the comparatively small investment bank would have triggered a global run on other financial institutions around the world and the situation would have spiraled out of control, he said in an interview with Swiss Sunday newspaper SonntagsBlick.

Gruebel, chief executive of Switzerland’s second largest bank from 2004 to 2007, said that central banks fortunately realized that they had to de facto take over the interbanking market.

‘We’ve narrowly escaped a system collapse. This has never happened before,’ Gruebel said.

I wonder about this last bit, and what a ’system collapse’ means in the current financial system vernacular. Craig Calhoun has been writing about ‘emergency’ and the ways that emergency has taken a rarified place in international relations, providing a moral justification for action that cuts across traditional notions of nation-state and interests, while also solidifying those very categories. Emergency implies anomaly, and particularly for things like humanitarian emergencies it provides a counterpoint to something like, say, ‘national interest’ as a way to mobilize international resources and attention.

I don’t want to push his point too much. But I think there is something similar going on in financial markets. Here we should substitute ‘crisis’ for ‘emergency’. But there are strikingly similar elements: a market crisis implies an anomaly in an otherwise working institution. That is, a market crisis suggests a global system of allocating risk and resources that works with glitches. An alternative would be a permanently failing system, one where market crises are the rule rather than the exception, and where the fixes to the system - governmental interventions on behalf of a small group of investors, while purporting to be acting in the best interests of the rest of us - don’t actually fix anything.

So let me sketch this out. A system collapse would mean the failure of trillions of dollars worth of notional value. This is not the same thing as saying the loss of trillions of dollars worth of wheat or US dollars or houses, but rather the value of the contractual obligations on which derivatives are built. If the wheat futures markets closed tomorrow, there would still be farmers growing wheat, selling it on the spot market to wholesalers, who would still make it into tasty Hostess Cupcakes. The futures markets for a number of hard commodities disappeared during WWII, replaced by price controls in the spot market, and well, people still ate.

In the currency markets, we would still have trade. In fixed income, banks would still issue loans, the US government would still auction treasury bills. You would still be able to buy AT&T stock.

What would disappear is two things: 1) an absolutely enormous amount of value for a small number of investment banks and related institutions - on the order of hundreds of billions if not trillions of dollars; and 2) a system for distributing risk, and its attendant costs/benefits.

For the former, that would indeed be a crisis. Well, for some people. It would have real effects, and dramatic ones for places like NYC which is built not just on the finance industry but on all the consumption patterns of high-income people.

For the latter, it would mean that risk would be managed more locally, and probably much, much, much, much, much, much more conservatively than it is now. It would be reasonable for a bank to give out a loan, but without the ability to lay off their risks in a global market they would do more due diligence. Ditto housing lenders, grain wholesalers, etc. The effect would be a massive tightening of credit and much more volatile prices for commodities (both physical and financial).

And that’s it. The argument that we need global finance is simply a status quo argument, not necessarily a substantive one. And while there was (and is) economic justification for the global structures of financial markets - making the distribution of resources more efficient - these justifications have not always held sway, even in finance. Their seeming solidity is a mid-20th century invention at best. A collapse would be a massive change. But it would not be Armageddon.

2 Responses to “What would a system collapse look like?”

1. Andrew Says:
   April 30th, 2008 at 11:31 am

   I know not one whit about economic sociology or the world of finance, so feel free to ignore this or pick it apart as nonsensical. But, chewing over this scenario a bit, I wonder if other markets - such as the currency markets - would be as insulated from system collapse in the financial markets as this suggests? I think of a crisis as not only introducing glitches into the a system of allocating risk and resources but also an interruption in the production of confidence that affects whether an organization is able to see a risk as a ‘risk’ rather than as a non-starter, or conversely as producing new kinds of risks (such as pumping $ into a failing bank) that may end up restoring normalcy or triggering a whole new state in the system. E.g., I think the Fed’s actions in the Bear Stearns case has been generally applauded, but what if they hadn’t done anything (risk 1) and even if they did that the deal fell apart or hadn’t worked?

   Does any of this make sense? Sorry if it doesn’t.

2. Peter Says:
   May 1st, 2008 at 9:45 am

   Oh, I actually think that currency markets will indeed by affected by a system collapse, and greatly. But for a bit more historical perspective, we’ve gone through more than one dramatic, institutional system change in currency markets during the last century, the rise (1944) and fall (1971) of Bretton Woods being the most dramatic. On the gold standard, banded global agreement on currency exchange, closing the gold window.

   The ‘too big to fail’ is pretty new as well, being formulated around the 1984 imminent collapse of the Continental National Illinois Bank and Trust - The argument that contemporary investment banks are too enmeshed in mutual obligations to let them fail is thus pretty compelling in the sense of ‘if we don’t save BS’ positions, we’re staring into the void.’ But it remains to be seen what would actually happen, beyond paper losses.

   During WWII, they suspended any trading in lots of commodities. And FDR made it illegal for individuals to own gold. I guess my point is that just because the current system ‘works’ doesn’t mean it is either inevitable or that we couldn’t live without it.

   BTW, I absolve you from all future ‘not knowing one whit abouts’, so you can comment without the apologies from here on in

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