Thursday, May 15, 2008

Explaining the Credit Crisis: Act I

To understand the current credit crisis it is instructive to go back in time and think about the rise of what I'll call "global capital." Global capital is the pool of money that comes from worldwide savings that can be invested anywhere. From there we can then think about what effect that ever increasing (and huge overall) pool had on the securities industry in the US. Finally we can discuss the actions of the Fed and talk a little about future steps to avoid such a crisis in the future.
Where did this global pool of money come from and why is it so important? One place to start is the microcomputer revolution. Computers and the internet have connected global financial markets like never before. I also believe that computers and the internet have been a key factor in the enormous rates of growth seen in some parts of the developing world, especially East and South Asia. So If we are looking for a culprit for the credit crisis, why not blame Bill Gates, it usually works for other things...

But seriously, computers both created a lot of wealth and facilitates its easy movement around the globe. The first real wave of global capital that led to a speculative bubble was capital generally from the west that went looking for newly evolved capital markets in SE Asia. It found Thailand, among others, and rode a wave of speculative real estate investment and loose banking regulations (read: bad loans) until the bubble popped. Suddenly all capital in Asia got cold feet and started fleeing at an incredible speed. This led to the big bailout of Long Term Capital Management that took heavily leveraged bets on Asia.

That was a bit of a preview of the 21st century except for the fact that in the 2000s, most of the new capital was coming from the developing countries to the West. There was one problem, usually this capital liked the safety and modest returns of US Treasuries - US debt. But this was a period when the US Fed was keeping interest rates extraordinarily low, the European Central Bank as well. So the returns on US Treasuries was almost zero. This capital went looking for another outlet.

Here is a look at the growth in the pool of global capital:

Notice how it has risen from $12 trillion in 1980 to $167 trillion in 2006. (Source: McKinsey Global Institute - this is equity securities, private debt securities, government debt securities and bank deposits combined)

Notice also the balance of payments disparity between the US and the developing world. By 2006, the US has a current account deficit of over $800 billion while the developing world was running a surplus of almost $600 million. The world has changed and this giant pool of capital is looking for a place to park....
Tomorrow, Act II

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