End of the cult of finance?

J K Galbraith once observed that all financial crises produce similar responses: someone has to be blamed; there is a headlong rush to regulate and reform; and, amid the intense focus on the idiosyncrasies of the crisis, the thing that actually caused it all in the first place—speculation—gets overlooked. The celebrated economist, who died just over two years ago, would have recognised the credit crisis that began last year, and its aftermath, as entirely typical.

Accusations and the rush to regulate are all around, but there is little discussion about how we allowed speculative fever in housing and financial markets to become so intense that it turned into a bust.

With The Trillion Dollar Meltdown, Charles Morris has made one of the first efforts to explain why the credit bubble was allowed to inflate so grossly. If his book has a defect, it is that it focuses too narrowly on the US. This is a western financial crisis, if not quite a global one. But this should not detract from his achievement. Morris sets out to explain to a layman how esoteric problems in US mortgage financing in early 2007 exploded into a major credit crunch. To do this, one needs context: much of the book is devoted to examining the key political and economic shifts since the 1970s.

Morris's assessment of the scale of the financial damage—the $1 trillion of the title—may seem big, but it is fast becoming accepted wisdom. The IMF recently produced a comparable estimate, although the banking industry is still lagging behind with a consensus figure of about $600bn. In the end, a full measurement of the crisis can only be made once we have accounted fully for future asset price changes, including the eventual decline in house prices and the costs associated with a recession or economic slowdown. Once all these numbers are in, Morris's trillion may actually end up being an underestimate.

So in the long history of financial crises, this looks to be a biggie, and will take a long time to clean up. $1 trillion represents over 7 per cent of annual US GDP. The rescue of America from financial crisis in the 1980s, involving its so-called savings and loan associations, cost about 2.5 per cent of GDP, while Japan's banking crisis in the 1990s cost about 10 per cent of GDP. We have largely forgotten about the former nowadays because the authorities acted with speed and managed it successfully. After about two years, the economy and stock prices had started to recover. But we still talk about the Japanese crisis because the authorities spent too long in denial and failed to address the key problems for the first few years. Japan's economy went through three recessions in the 1990s, and even today, the Nikkei 225 index of stock prices is little more than a third of its 1989 all-time high.

If today's credit crisis is not to leave a Japanese-style scar on our economies, the authorities will have to restore order to dysfunctional financial markets. In the US, the omens have been encouraging, but the presidential election is, perhaps inevitably, leading to a loss of momentum and commitment. Two processes will have to be fixed before any recovery can be made. The banks need to be recapitalised—something that has only just started. And consumers in the US and Britain need to rebuild their personal savings. Given that US households start from a zero savings rate, there will be no sustainable recovery much before 2010.

As to the "why did it happen?" question, booms and busts are part of the human urge to speculate, which we cannot or do not control. As Galbraith observed, booms arise from a poor memory, so that each new generation proclaims its brilliance in financial innovation—confident in the "the specious association of money and intelligence." On this occasion, the specious association was expressed through financial instruments such as structured credit, derivatives, asset-backed securities and CDOs (collateralised debt obligations), instruments that Morris's book lucidly explains. But they were no more the cause of the crisis than a car's accelerator pedal is the cause of a road accident.

In his search for the culprit, Morris goes back to the conquest of inflation in the early 1980s under Paul Volcker, chairman of the Federal Reserve, and the restoration of the dollar after the crises of the 1970s. This gave a new lease of life to the US economy. But how was the plot then lost? The 1980s brought a new and market-friendly ideology into government. Free markets and financial deregulation favoured the expansion of financial services and the provision of and access to credit. Surely a good thing, no?

Up to a point. Although low inflation is a good thing, you have to appreciate its significance for the financial world. Lower inflation means lower interest rates, and that means a bigger incentive to boost returns. Most often, you do this by using leverage—borrowing money to invest in something. As asset prices rise, investors borrow more and more against them. History shows these periods of sustained low inflation tend to be accompanied by asset-price bubbles—and that's something central banks should have pounced on.

The laissez-faire attitude of the monetary authorities, combined with the financial innovations of banks, led to what Morris calls the "wall of money" as new and progressively looser credit practices and instruments (the alphabet soup of CDOs, ABSs and so forth) created liquidity far in excess of what was sustainable. Under Alan Greenspan, the Fed cut interest rates aggressively whenever there was financial turbulence: in 1987 (stock market crash), 1995 (Mexico crisis), 1998 (Long Term Capital Management hedge fund collapse) and 2001 (9/11 and dot-com and capital spending bust). Credit was created in unregulated or weakly supervised parts of the financial sector through the use of leverage by banks, special entities created "off-balance sheet" by banks, hedge funds, private equity groups and in derivatives markets.

So in the end, if there is a finger of blame, it points unequivocally at the authorities—the central banks, financial regulators and, ultimately, governments. Central banks control the money supply, using interest rates and other measures to influence economic, credit, monetary and liquidity conditions. They or other regulatory bodies set the rules for financial transactions and stability. It is not credible for these authorities to claim that it isn't their job to take a view about asset-price inflation as well as retail prices. The more successful central banks are in subduing consumer price inflation, the greater the probability of asset inflation—as we have seen for centuries. To have a 2 per cent inflation target and ignore sustained double-digit house price inflation is like following a strict food diet while drinking unlimited alcohol.

In Britain, financial stability was compromised, as we now know, first by the Gordon Brown's decision to split up the system for regulation and supervision between the Bank of England, the treasury and the Financial Supervisory Authority. This was compounded last summer by the Bank's initial refusal to recognise systemic risk, followed by its half-hearted response.

Blaming the Bank or the Fed alone is unfair, however, because national authorities no longer operate only within national boundaries. In effect, the US has overconsumed, resulting in record external deficits that have been financed by China and other emerging markets. These imbalances have grown substantially in the last ten years, resulting in a large accumulation of US dollars in the emerging markets (and Japan), which have been recycled back to US money and capital markets, putting downward pressure on long-term interest rates. This is what Greenspan calls the "interest rate conundrum," in which long-term interest rates stay the same or fall, even when the central banks are raising their short-term rates.

There was a broader collective failure to manage the global economy and monetary system. Since 1989 we have drifted into laissez-faire globalisation, which has lifted millions out of poverty, but also generated great costs and discontent—from widening income inequalities to concerns about immigration.

The US economist Hyman Minsky postulated a valuable template for the understanding of financial instability, one only touched upon by Morris. A year ago, I first wrote about the "Minsky moment"—the point at which systemic risk in the financial system threatens a meltdown and demands unorthodox intervention to restore stability. The Federal Reserve and the Bank of England have recently drawn a line, in effect declaring that large, high-profile financial institutions will not be allowed to fail. This is an essential step. It conflicts, of course, with those who claim that this is "moral hazard" (letting lenders or investors avoid the consequences of their risky behaviour). But the time to worry about moral hazard has long passed. The costs of inaction are now too high. In democratic countries, public authorities have to intervene, and yes, it's possible in the process that some lenders or investors will be bailed out who shouldn't be. So be it. Government must then act to restrict such risky behaviour in the future.

The fact that we have just had such a Minsky moment suggests that government involvement will now steadily expand. The US congress will have to redouble efforts to provide a legal framework for borrowers and lenders to work their problems out rather than walk away. Governments may need to use public money to fund the recapitalisation of banks. The quid pro quo for this will be greater regulation. Governments will require banks to maintain more capital in relation to their assets than has been customary. The list will extend to liquidity provision, risk management, transparency and disclosure by banks, the role of credit rating agencies, and the ways in which securitised asset markets can be made safer.

In the rush to regulate, we may overdo it and stifle innovation. It is hard to predict where we will end up. But one thing is for sure. The financial landscape for lenders and borrowers is going to change over the next few years. The era when financial institutions generated a third of all company profits and many new jobs is over. The cult of finance will be eclipsed—at least until it adjusts to the new world in which it finds itself.