Brad Setser

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Systemic crises

by Brad Setser
October 2, 2008

A systemic financial crisis is one that affects the “system” — not a single institution. In my view, the US — and perhaps the US and Europe — are now facing one.

Systemic crises aren’t new. Many emerging economies experienced a systemic crisis when their currencies crashed in the 1990s, as most of their financial institutions either than foreign currency denominated debts and domestic loans or had lent in foreign currency to domestic borrowers who had no foreign currency revenue. Nor are foreign currency denominated debts the only cause of systemic crises: Japan experienced a systemic crisis in the 1990s because its banks had lent heavily against domestic real estate.

American financial institutions recently lent too much money to American households on the assumption that real estate only went up. The also assumed that macroeconomic and financial volatility had been vanquished, which meant that higher level of financial leverage made sense. The result is now obvious.

Systemic crises are particularly hard to resolve because most large institutions, by definition, have the same underlying financial exposure. If a host of large institutions all have the same problem and all want to get rid of the same bad bet, the overall result is that there are structurally far more sellers than buyers. If most leveraged institutions made the same bet, the problem is compounded: leverage magnifies the downside as well as the upside. The result is something not far from the “great unwind” — though the trigger for the unwind is a bit different than the one Staiman and Kips initially identified. A host of leveraged institutions all want to cut back on their leverage and sell their risky assets — something that is hard so long as everyone is trying to sell at the same time. Warren Buffet (hat tip Steve Hsu of Information Processing) puts it well:

all the major institutions in the world trying to deleverage. And we want them to deleverage, but they’re trying to deleverage at the same time. Well, if huge institutions are trying to deleverage, you need someone in the world that’s willing to leverage up. And there’s no one that can leverage up except the United States government.

That doesn’t necessarily imply the only possible policy response is buying bad assets; equity injections could play a role too. There are plenty of ideas out there — including this proposal by Morris Goldstein. It does though imply that the government has to play a role in resolving the crisis.

Anna Gelpern* has noted that the dynamics of a systemic crisis also apply to over-stretched households. Normal processes break down when too many households are in the same position — namely underwater on their mortgage. She writes:

In ordinary times, failure is resolved case by case. People and companies negotiate with their creditors, and when all else fails, file for bankruptcy. There is a judge for every case, a plan for every debtor and a price for every asset. But in a mass crisis, there are not enough judges or hours in the day to process failure. When everyone is selling, the right buying price is anyone’s guess. That is when governments resort to wholesale, one-size-fits all solutions.

She is right. If only a few home owners cannot make payments, a case-by-case approach works. But in circumstances when many homeowners are under-water and bankruptcy is, at least in some places, the norm, the case-by-case approach breaks down. The courts — indeed, the banks — are overwhelmed.

While all systemic crises are unique, they do — as Gelpern notes — give rise to similar choices: choices over whether to renegotiate contracts in mass rather than rely on a case-by-case approach even if this sacrifices a bit of equity (Gelpern writes “The good are punished with the bad, and the bad are bailed out with the good “) for efficiency, and choices over how to allocate losses among creditors, debtors and the taxpayer.

The choices that the US has to face now aren’t a surprise — at least not to those who have thought extensively about systemic financial crises. The surprise is that the United States is having to face these choices. As former Treasury Secretary Summers notes in the Wall Street Journal:

“Superpowers do not normally ask their diplomats to reassure other nations on questions of credit-worthiness”

They also haven’t generally had to struggle with the same difficult choices emerging economies faced in the 1990s.

* Anna and I worked together when we were both at the Treasury from 1997 to 2001; she is a dear friend. She also is now a blogger!


  • Posted by adiemuso

    Twofish Says: “I don’t think too many people in China want the US to fail. Lots of people in Southeast Asia do because of the Asian Crisis.”

    As a Singaporean living in South East Asia, I believe I am qualified to wake you up from your little mob lynching delusion. USA is a major Trading and Investment partner with the South East Asian countries. It would be delirious for any government or anyone to even contemplate such a demise for our biggest business partner. Either you are biased or you are severly lacking an acute sense of business judgement and sound analytics.

    bsetser: “if Asian economies want the US to fall, they will quickly need to find someone else to buy their exports. China in particular.”

    We are in a modern global world. Countries and Economies are more interlinked and interconnected than before. Asia and the rest of the world are not insulated from the wellbeing of the USA. And the current episode has debunked the myth which foolishly believes otherwise.

    I do agree with Brad, that China needs to step up in the global scene. China has to come out of the world exporter of cheap goods label into a global importer of world goods. It takes time for comparative advantages and rigid foreign exchange regimes to even out and adapt. However, the Chinese has to speed up and fill in the gaps the USA is leaving.

  • Posted by a

    There’s been a lot of talk about Peak Oil. I think what we are witnessing now is Peak Debt. The world financial system couldn’t absorb any more debt. It had to come down.

    I like the Yu Yondging comments. Naked Capitalism had a post about it when it came out.

  • Posted by Twofish

    adiemuso: As a Singaporean living in South East Asia, I believe I am qualified to wake you up from your little mob lynching delusion.

    One reason I’ve been thinking about lynch mobs, is that while I expected that there would be some hostility toward Wall Street, I didn’t quite expect the huge outpouring of anger that came out this week.

    I think it would be irrational and self-destructive for people to try to take the United States down, but just because something seems irrational and self-destructive (at least to me) doesn’t mean that people won’t do it.

  • Posted by ReformerRay

    Brad – what actions do you believe could be taken (meaning, planned in advance to be taken) by the Fed and Treasury Dept. to avert the true catastrophe of a momentum-building flight from Treasuries – not after it’s already in full bloom with cries of Armaggedon everywhere (like with the current problem), but as a preventative or early response to avert the catastrophe in the first place?

    Until our officials stop pooh-poohing this possibility (as they did the coming housing crash in 2005 and 2006) and start planning for it as a real contingency, no U.S. citizen or investor anywhere should feel safe.


  • Posted by Chuck

    It would be interesting to know your views:
    Is there any flight from the dollar as the international reserve currency?
    Are there decreased purchases of US Treasuries by global central banks?
    You might find a March 2007 paper by Ashok Bardhan interesting: It’s titled ‘Impact of Global Capital Flows and Foreign Financing on US Mortgage and Treasury Interest Rates’; and is easy to google up as a .pdf document.
    Best regards,

  • Posted by bsetser

    chuck — read my next post! the fed’s custodial data suggests ongoing central bank purchases of us treasuries. i’ll look at the bardhan paper

  • Posted by leslie katzenmeier

    To think our finest CEOs and economists (one of whom, Bernacke, wrote the book on the “Great Depression)are unable to see ahead, the results of their policy or lack of policy, is ignorant. This started with alan Greenspan’s interest lowering (dollar flooding and cheapening), and relyed upon ones common greed for short term gain, triumphing over the forseeable long term disaster this recipe creates.

    Like a game of musical chairs, you only hope to keep your seat while the party still rages and like the card game old maid, hope to hand off the old bag card when it’s accountability time..

    This will bring a global cooperation in order to stave off a sure disaster, ending in the revelation that we are better together than apart. Why not have one currency and create together, policy and reform. What a revelation.

    The U.S. will not retain status of global superpower. We will and have already lost our hedgemoney in the global marketplace.

    This is a necessary destruction in order to erect the new order.

  • Posted by leslie katzenmeier

    Like the one party system we currently have, none of the candidates will go on to run this country.

    We will also have a new political system as part of the financial restructuring package, I believe.