Column by Marcel Canoy (chief economist ECORYS Netherlands) and Max van der Sleen (chair ECORYS Board of Directors), with thanks to George Barrett (chief economist ECOTEC)

16 October 2008 – The current worldwide financial crisis has dominated the headlines for weeks now. Every Monday seems a new Black Monday. Stocks keep plummeting and people are getting increasingly nervous that this is not only a banking crisis, but that we might be standing at the edge of a real economic and financial abyss. Strong language, but is it an abyss or are we just experiencing a temporary shock?

What will happen to people who are in the process of getting a new mortgage from their bank, while their current home is still on the market? The financial sections in the papers keep bringing us worrying signs about the stock markets. What is happening to our money? Where are we now?

‘Confidence’ is the magic word
First things first. A short while ago we were gloating at the Americans. But after the ritual Bush bashing the focus is now on Europe. The magic word is ‘confidence’. The question is no longer whether Europe is affected, but for how long we will be affected and how to what extent.

Subprime
The historically low interest rates in Europe and the US have boosted the world economy for a fairly long period. Fine. But they also triggered greed. Greed by financial institutions, greed by house owners, and greed by governments. The risks seemed low, the returns lush. Subprime loans were the most obvious manifestations of this. Millions of citizens, corporations, and governments were lured to borrow and spend more than they could afford. And this is all the more true in the US where one is allowed to dream and count on luck, and where failure is not failure but ‘at-least-he-tried’.

Special purpose vehicles
When interest rates increased, people could no longer afford their houses. We now know the rest. But subprime products were perhaps the trigger but not the cause. If this were the only story, the effects would have been limited to the housing market and to the US. The deeper underlying cause was that banks created innovative products that liquefied illiquid assets. In itself no problem, but with these products (the infamous SPVs, special purpose vehicles, the word ‘special’ sounds a bit funny in hindsight), nobody knew who was taking what kind of risks. And this was not just a US thing. Most financial institutions were somehow involved, or potentially involved, since the problem was that nobody knew exactly what was going on.

Lack of trust
This lack of transparency caused banks not to trust themselves and their risk models anymore, let alone to trust their peers. Just like a pyramid game, this will fall apart at some stage. All of a sudden the lush returns do not look that lush anymore. The lack of mutual trust essentially dried up the market for inter bank credits overnight, a historically unique event. And we are suffering from lack of trust as of today.

The analysis
Many analysts have blamed governments for faltering with their saving plans. And it is true that some have made ‘silly’ mistakes. But it is not so easy. Typically we don’t like to nationalize our banks. We don’t even necessarily like to save banks that have taken too much risk. So we try not to do that. If a government decides whether or not to save banks, they have to trade off stability issues resulting from falling banks with moral hazard dangers associated with still alive but weak banks. This is not so obvious, since moral hazard is a difficult to assess long term effect while the stability is an equally difficult to assess short term issue (with long term implications if you get it wrong). Nobody knows exactly how to assess these things. So Lehman goes and Fortis stays. Fair enough.

And now?
Whether or not the current rally is a sign of recovery nobody knows, but we can already see effects of the crisis on the real economy. Credits are crunched for citizens, banks and companies. Governments have to step in. But for how long? Confidence has to be restored as soon as possible because it is not the government’s core competence to assess risks and creditworthiness. Pension funds see their asset value shrink, and threaten to become undervalued. Meanwhile tax incomes shrink as well. Citizens will not start spending unless confidence has been restored.

One cannot see anything else but government interventions to be temporary. Despite the major hiccup there is no plausible alternative for our capitalist and financial system, so at some point banks have to pick up the pieces and get on with the job. On a world scale this may have been a major economic disaster, it does not mean that the system is dead. In a sense it shows capitalism is alive. As with bodily pain, it warns the economic body that it hurts, that something needs to be done to stop the pain, and to avoid unnecessary future pain.

Restoring confidence
How can confidence be restored? Only if we understand the problem and believe in the solutions. Some steps in the right direction have been taken, notably with the Europeans at the helm, but we are not there yet. Confidence is a public good, and hence needs a coordinated action to be restored once it has disappeared. ´Building the future together’, has long been one of ECORYS’ mottos. And it should be the motto for the world leaders. Is it going to happen?

The US still seems to live in the past where they were calling the shots (no pun intended). Hopefully things will resolve after the elections. Time will tell. Meanwhile, Europe has to make use of the political will to stop the floods. The fact that the crisis has reunited Europe with the US as a follower is a positive sign and possibly the start of a new political world order.

To conclude
To paraphrase Dutch columnist Johan Schaberg: “We are in a crazy rollercoaster. Nobody knows for how long and whether we will leave in a safe way. But we’d better enjoy the view while we are in.” There is no real alternative for our capitalist and financial system. We need to fight excesses without throwing the baby with the bathwater. And yes, and we should not forget to be less greedy ourselves.