Samuelson: The Engine of Mayhem

It's easy to explain the continuing financial chaos—and the failure of governments to control it —as the triumph of psychology. Fear reigns, and panic follows. Everyone dumps stocks because everyone believes that everyone else will sell. Only rapidly falling prices attract sufficient buyers. All this is true. But it ignores the real engine of mayhem: "deleveraging." That's economic shorthand for purging the financial system of too much debt.

Just how this deleveraging proceeds will largely determine the fate, for good or ill, of the crisis. The turmoil has already moved beyond "subprime mortgages," which (it now seems) merely exposed widespread financial failings. These were global, not just American, and their pervasiveness explains why leaders of the major economies have struggled, so far unsuccessfully, to fashion a common response.

Alone, American subprime mortgages should not have triggered a global crisis. Losses are smaller than they seem. Mark Zandi of Moody's estimates that all U.S. mortgage losses will ultimately reach $650 billion. But that hefty amount pales against the value of all financial assets—stocks, bonds, bank loans. For the United States, these totaled almost $60 trillion at the end of 2007; for the world, the comparable figure exceeded $250 trillion.

Such a vast financial system should have absorbed the subprime losses without calamity. By way of contrast, the stock market's drop since its peak in October 2007 to Friday was $8.4 trillion, or 42 percent, reports Wilshire Associates. The official response to the subprime losses also seems larger than the problem. The government has taken over mortgage giants Fannie Mae and Freddie Mac; the Federal Reserve is pumping out short-term loans of $1 trillion or more; and Congress's $700 billion rescue allows the Treasury Department to buy subprime securities and to make direct investments in banks.

Still, the situation has not stabilized; the crisis continues. It's as if more firefighters had arrived at a burning home and turned their hoses on the flames, but the conflagration raged anyway. What's going on?

What we've discovered is that the real problem is bigger. Large parts of the financial system are too thinly capitalized and too dependent on unreliable short-term debt. Leverage ratios often reached 30 to 1 for investment banks and hedge funds (that is, $30 of debt for every $1 of capital). The presumption was that the MBA types had learned how to "manage risk." That false conceit backfired. Low capital didn't adequately protect against losses. Confidence and trust evaporated, because no one knew which institutions held suspect securities, how much the losses were and who was ultimately safe.

Deleveraging—a shift from excessive debt toward more capital—is inevitable and desirable in the long run. The trouble is that, in the short run, it could destabilize the economy if it proceeds too rapidly.

Consider stocks. Their plunge has been driven in part by hedge fund selling. Hedge funds often buy stocks by borrowing from their "prime dealers"—firms such as Goldman Sachs and Morgan Stanley, which in turn borrow from commercial banks. If banks "deleverage" by reducing loans to prime dealers, then prime dealers tighten up on hedge funds, which react by selling stocks. "It's a big piece of why the stock market is down," says Michael Decker, former chief economist for the Securities Industry and Financial Markets Association and now co-head of the Regional Bond Dealers Association.

All around the world, we see variants of this cycle. Countries could face crippling capital outflows. The yen "carry trade"—borrowing at low interest rates in Japan and lending at higher rates in other countries—is reportedly contracting. Iceland's main banks have been nationalized because they couldn't renew their short-term borrowings. But if credit is withdrawn too abruptly, the prices of stocks, bonds and other assets that it propped up—and also the real economy of production and jobs—will fall. And the effects feed on themselves. Hedge funds, for example, have been hit with high redemptions from investors: about 5 percent in September, 2 1/2 times normal, says Charles Gradante of the Hennessee Group. These compound selling pressures.

The present challenge is far more complicated than merely quarantining dubious mortgage-related securities. What's involved is a fundamental remaking of the global financial system, from one that was inherently fragile to one that rests on firmer foundations. But if the change proceeds too quickly and haphazardly, it risks a hugely destructive credit implosion. All the policies undertaken so far will ultimately be judged by whether they succeed in managing the transition and restoring confidence in financial markets that self-correct naturally—as opposed to submitting to the continuing mayhem of uncontrolled deleveraging.