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  • Apr 20, 2014
  • Updated: 11:03am
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PUBLISHED : Friday, 17 August, 2012, 12:00am
UPDATED : Friday, 17 August, 2012, 5:54am

Five years after crisis began, we still can't see the elephant

Pinning the blame for the past half-decade of turmoil on hedge funds, banks, regulators, homebuyers or ratings agencies is to miss the truth of the big picture

The global financial crisis is five years old - more or less. There is some disagreement over when precisely it began. A lot of newspapers now seem to have fixed on August 9, 2007, as the fateful day. But looking back through the archives, I see the South China Morning Post warned US credit markets were in crisis on August 3, a week earlier.

Whatever the exact date, the convulsions have gone on ever since. First we had the credit crunch, then the bursting of the mainland stock market bubble, followed by the commodity boom that saw the price of oil hit a record US$144 a barrel.

Then came the implosion of Lehman Brothers, a stock market crash that wiped US$20 trillion off the value of shares globally, the collapse of world trade, recession in the developed world, and finally the euro-zone's debt crisis, which continues to weigh on economic prospects around the world.

In that time, blame for the crisis has been pinned on all sorts people. Accusing fingers have pointed at hedge funds for shorting the market, at regulators for negligence, at subprime homebuyers for reckless borrowing, at ratings agencies for failing to accurately assess credit risk, and of course at bankers for excessive greed.

The identification of so many culprits by so many commentators recalls the story of the blind philosophers and the elephant.

One grasped the animal's trunk, and declared the elephant to be a snake. Another felt its tail, and said it was a rope. A third felt its leg and announced the elephant was a type of tree. The fourth touched a tusk and said it was an enormous … But you get the idea: none of the philosophers saw the whole picture.

Similarly, in blaming the current turmoil on hedge funds or bankers, legions of commentators have demonstrated a worrying failure to understand the true cause of the current crisis: that the past five years of financial and economic instability were the inevitable consequence of the long period of stability that preceded them.

That's because stability itself naturally breeds turmoil. Extended periods of apparent calm, like the one much of the world enjoyed between 2002 and 2007 during the "great moderation" of low interest rates, low inflation and falling volatility, are dangerously misleading. Lulled into a false sense of security, lenders relaxed credit standards, while regulators grew complacent and loosened supervision.

At the same time, low borrowing costs encouraged investors to leverage up in the hope of higher returns. The result was an explosion of debt and an orgy of risk-taking.

To make things worse, people had little choice but to participate.

Since the crisis everyone has been quick to condemn bankers for running excessive risks. But consider the fate of those bank executives in the years before 2007 who didn't join in the party, and who refused to set up securitisation departments, derivatives businesses, proprietary trading units and the like.

Because funding costs were cheap, volatility low and investor risk appetite high, the bankers who did leverage up their balance sheets to enter new and riskier businesses made enormous profits.

As a result, their more conservative colleagues faced awkward questions from shareholders about their low returns on equity relative to competitors, and their stock prices suffered.

Many of the more risk averse were sacked and replaced by younger bankers more ready to load up on risk, while the banks that failed to leverage up got taken over by more profitable rivals.

In short, everyone took excessive risks during the period of apparent stability because if you didn't, you didn't survive.

Unfortunately, the stability was illusory. Eventually, in August 2007, the bill arrived and we've been paying it off ever since.

But whether we have learned our lesson is doubtful. Around the world, governments and central banks have responded to the crisis by attempting to create yet more liquidity and still more credit.

As a result, supposed safe haven government bonds have climbed to record prices, while this week the volatility of the US stock market fell to a low not seen since the beginning of 2007, just before the outbreak of the crisis (see the chart).

That's worrying, because when volatility falls to near record lows, there is only one way for it to go: upwards. And historically, a sharp rise in volatility has usually meant a big fall in prices.

Five years after the crisis began, the elephant may be about to stomp on us all over again.

tom.holland@scmp.com

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