are we having fear yet?

the cerebral insult theory of financial crises

Thanks very much to the reader who asked me one of those simple questions that gets you thinking – “are you worried?”, juxtaposed with a link to one of the latest stories about credit markets. I try not to do too much “current affairs”, but thinking through what kind of an answer I might give to that was very useful for the general project of whatever it is that this Substack is about.

A number of answers come to mind, the first (and therefore probably best) being “the regulators are worried, so I’d be a fool not to be”. There is a lot of debt out there, there are lots of signs of slowing down, the full impact of tariffs has not been felt yet, etc etc. When the deteriorating conditions for cash flows hit the limits of the financial system’s ability to extend and pretend, a lot of people are going to have lost a lot of money. It will suck.

But of course, merely sucking is not the kind of economic outcome we would be scared by, we readers who remember 2008. And so (also because I’m thinking a lot about crises), I think a fuller answer would have to involve first thinking about what happened in 2008/9, what made it so bad and how those things resemble today. If the conditions are analogous, we can start worrying a lot; if they’re not, we are back to thinking of solutions for ourselves without the aid of history.

So … my starting point for thinking about the Great Financial Crisis is that it was a cognitive shock – a kind of head injury to the overall economic system, damaging one of its important organs so that it was no longer able to perform a vital function of balancing present consumption and investment for the future. That’s why (and I think economics ought to regard this as more of a puzzle than it does) the financial crisis, which caused practically zero physical destruction of productive capability, left scarring and after-effects for more than a decade, while the COVID-19 pandemic, which killed millions and left lots of buildings unusable, was all reversed within a couple of years, with a fairly trivial inflation by past standards as the worst economic consequence.

I wrote about this in the context of comparing us to China:

The “Lehman Moment” was entirely a control failure. What caused the damage was that the information processing system was hit with something it couldn’t handle, and so it stopped being able to do its job. Consequently, since a lot of the economic system was built in such a way as to require the particular mix of control, information and accounting co-ordination that is provided by the financial system (for brevity, let’s call this “money”), the real economic damage was wildly out of proportion to the actual losses suffered by Lehman Brothers.

The specific thing that the system couldn’t handle was a very rapid increase in the uncertainty attached to the value of financial assets, which had the effect of making every element of the system less sure that it could meet its own obligations, in a cascading manner. Basically, the system was built on the assumption that certain kinds of interbank obligations could be treated as completely risk free. As we’ve noted before, an item treated as if it has zero risk has no constraint on its ability to grow, so these claims multiplied up in huge volume. Which meant that if you relaxed the assumption of zero risk even a little bit, the bandwidth needed to manage the system increased hugely.

What’s needed in that sort of situation is for some deus ex machina to step in and restore certainty – either the certainty that the asset is good, or the certainty that your money’s gone. Which is what happened with central bank and government action, eventually. But it was very difficult, because the system wasn’t set up for this kind of centralised action.

So, comparisons to today – there is, as I said, a lot of debt about. But nothing like as much of it is being held on the assumption that it was risk free, and nothing like as much of it is financed by multiple layers of leverage. (At least, that’s what we hope! A lot of what is worrying the regulators is that this market is not transparent and has grown very fast. My perception is, though, that although there will be overlapping and circular exposures, this stuff is mainly being held institutionally on the basis that it is a risk asset, which ought to mean that capability has been allocated to manage it when it goes bad).

Good-oh. The other side of the coin is less reassuring, though. The actual reason that the Global[1] Financial Crisis had such bad long-term effects and the pandemic didn’t is that one, but not the other, of these things was accompanied by a deluge of public sector money and private sector loan forbearance. And this was done at least partly precisely because the previous experience had been so bad; flooding the zone with cash made sure that it wasn’t overwhelmed with the flashing red lights of “BORROWER CAN’T MEET CASH CALL”. It would be nice to know that this is now the standard operating practice for similar crises. But I don’t think we do know that, and this is worrying.

[1] or Great, another one of these things that I really don’t propose to be consistent about.