By John Authers  November 7 2008

Arguments over who to blame for getting us into this mess are already getting tired. The blame is spread very wide and goes back a long way. But now we can begin a debate over the decisions that have been made since the crisis started. Which of them were mistakes?

The principal warriors against the crisis have been the world’s central banks. Their main weapons are interest rates. They have responded very differently. As last year dawned, the Federal Reserve had higher rates, at 5.25 per cent, than the rest of the G7; the Bank of England, battling against a growing inflation problem, was only slightly behind at 5 per cent; and the European Central Bank was at 3.5 per cent. All were facing essentially similar economic conditions. And yet their positions are now reversed. The Fed cut all the way down to 1 per cent; and the ECB, which raised rates three times during the crisis, including as recently as this July, now has the highest. Those different responses were critical in converting the credit squeeze into the acute global financial crisis of the past two months. This has less to do with the subprime fallout and more to do with two remarkable phenomena: the boom in oil and the collapse in the dollar. The oil boom tracked the rise in the euro against the dollar (a logical relationship as commodity prices are denominated in dollars, and higher commodity prices lead to sales of dollars). Both went into overdrive in early 2008, reaching what in hindsight were obvious bubble proportions in midsummer. They did this even though the credit crisis had bitten in July of 2007 while the equity market had peaked in October. At that point, oil would still double before reaching its peak. Two central bank decisions were critical in getting it there. First, the Fed cut rates by 1.25 percentage points during January after an ugly stock sell-off in Europe. Markets bet that lower rates would spur inflation (helping commodity prices) and that the dollar would weaken against the euro. The perceptions created by the oil spike led to policy errors that further reinforced it. Faced with a sharp increase in the price of a fundamental commodity, regulators decided that the greatest danger was inflation. Hence the ECB promised in June to raise rates. This fuelled the last spike for oil and the euro. They were now at unsustainable highs and the twin bubbles burst in mid-July after the ECB had made clear that that month’s rate cut would be its last, while Ben Bernanke of the Fed had warned that the US faced recession. How could these errors have been avoided? The January swoon in European markets had much to do with Jerome Kerviel, the rogue trader at Société Générale. That suggests that the Fed’s huge rate cut was unnecessary. Had they been better informed of the reasons behind Europe’s swoon, they might not have made the cut. As for the ECB’s July rate rise, it might have been avoided if the bank had had the confidence to see oil for what it was: a bubble. Many hedge funds had piled into the trade of shorting financials while investing in oil, and many in the market could see that the situation was untenable. The bursting of the bubble wrongfooted many hedge funds and investment bank trading desks, setting the scene for the death throes of Lehman Brothers and the wave of forced selling that would come in the autumn. So the errors might have been avoided if the regulators took a more global perspective, sharing information and drawing it from multiple sources, and if there had been greater awareness of the systemic risks across markets. Avoiding these errors does not require any increase in the burden of regulation. Rather it would have required more formal international co-operation (maybe like the “Bretton Woods II” floated by the United Kingdom prime minister Gordon Brown), and maybe a “process that identifies systemic risks to the financial system” (such as the oil bubble), perhaps through the creation of “a financial market oversight commission”. The words in quotes come from a speech by President-elect Barack Obama in March this year, so it looks as though the world’s political leaders at least understand what changes are needed – although much depends on getting those changes right. What are the lessons for the rest of us? Ultimately, it comes down to the elusive quality known as emotional intelligence. When faced with scary developments such as the January stock market swoon or the oil bubble, we need to keep our emotions disengaged. That way, we may be able to see a bubble for what it is. Another part of emotional intelligence is to have the courage to be too early. Market pessimists who ended up profiting from the events of the past two years generally placed their bets a long way in advance. For regulators and investors alike, the trick is to step back; try to see the big picture; and then have the patience to act based on that big picture.

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