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When metaphors collide
Apr. 2nd, 2008 02:03 pmThe experts in white coats like to use metaphors when it comes to describing how 'the city' works. Joe Plumeri (Willis boss) refers to insurance as "the DNA of capitalism". One could argue in response that it's more the DNA of wimp capitalisam where no-one is willing to take a gamble that might leave them broke. But, well, since wimp capitalism is now the default, I guess that this does not devalue the strength of his point.
The financial services sector (passim Mikey a few posts down) talks about the banking system prioviding "liquidity" and (not Mikey's quote, but one that you find in many places) "oiling the wheels of capitalism".
The problem with these metaphors, as with the Descartian model of the body as some kind of mechanistic clock and the mind as its controller, is that one can mistakenly take things which happen in the metaphor with things which actually happen in real life.
If you oil a wheel, but put on too much oil, then the excess just runs off. You might make a bit of a mess of the pavement, but no lasting harm is done. However, the oil is necessary. An unoiled wheel might, like an unoiled engine, cease to work.
The capitalist system follows the metaphor up to a point. Without the provision of liquidity by the banking system, the whole capitalist system can seize up. Nothing gets done.
However, a problem arisees when the banks are providing enough liquidity, but still have excess funds.
In other words, what happens when the level of available credit (oil) is too great for the economy (the engine)?
If you follow the metaphor, you might think that it would "run off onto the floor", but that isn't what happens. Once the banking system has performed its 'task" of oiling the wheels of capitalism, it still wants to make a return on its capital. If that capital (oil) is pumped into the economy (the engine) then it doesn't run off. It causes the economy to run differently.
We've seen the result of this in the past few years, with that oil turning itself into unsound credit, insured with insurers that, it transpires, won't be able to pay up if the bonds default. UBS, which a few months ago had $37bn-worth of such 'liquidity' pumped into the economy, suddenly realizes that the money is gone. Far from performing a function vital to the smooth running of capitalism, it was, in reality, transferring wealth from institutional investors in London to single-parent subprime borrowers in Missouri.
Whether that's a good or a bad thing is debatable. But there's little doubt that it isn't the kind of thing that UBS would cite as part of its positive contribution to the smooth running of capitalism.
++++
The UBS scenario is interesting because it raises an interesting hypothetical scenario. Many a political and (to their shame) economic commentator, appears to have assumed that there's a sequence of scenarios, each worse than the last.
Basically, if a bank gets into trouble, you go for a rights issue -- appeal to the investors to back you (see UBS). If that fails, then you look to be taken over at a cut-down price (see Bear Stearns). And if all of that fails, you look to the government to bail you out or take you over (see Northern Rock).
In other words, the worst case scenario is a government rescue.
This is all very fine if the financial institution is relatively small (e.g., Northern Rock, although even that is straining the Bank of England) or if the government is relatively large (the Fed). But what if UBS can't get a rights issue to work (even institutional investors have their limits) and can't find a white knight to take over its liabilities? There's no "state rescue" option here because, to be blunt, the Swiss National Treasury isn't that big. And you can hardly expect the American Fed to ride to the rescue of a Swiss bank.
In this worst-case scenario -- a bank which is large relative to the size of its domicile and is lalso a reasonable part ofthe global banking system — then you have the potential for a bank failure that could, indeed, cause some kind of systemic global financial crisis ('we've used up all the oil!!!!!'). What form that crisis would take and what its implications would be, I simply don't know, because we have never been in any situation that remotely resembles it. My guess would be that the world's banks would club together, take over the liabilities in bits and pieces, and the system would "muddle through". But a lot of people would suffer a lot of pain in the process.
_____________
The financial services sector (passim Mikey a few posts down) talks about the banking system prioviding "liquidity" and (not Mikey's quote, but one that you find in many places) "oiling the wheels of capitalism".
The problem with these metaphors, as with the Descartian model of the body as some kind of mechanistic clock and the mind as its controller, is that one can mistakenly take things which happen in the metaphor with things which actually happen in real life.
If you oil a wheel, but put on too much oil, then the excess just runs off. You might make a bit of a mess of the pavement, but no lasting harm is done. However, the oil is necessary. An unoiled wheel might, like an unoiled engine, cease to work.
The capitalist system follows the metaphor up to a point. Without the provision of liquidity by the banking system, the whole capitalist system can seize up. Nothing gets done.
However, a problem arisees when the banks are providing enough liquidity, but still have excess funds.
In other words, what happens when the level of available credit (oil) is too great for the economy (the engine)?
If you follow the metaphor, you might think that it would "run off onto the floor", but that isn't what happens. Once the banking system has performed its 'task" of oiling the wheels of capitalism, it still wants to make a return on its capital. If that capital (oil) is pumped into the economy (the engine) then it doesn't run off. It causes the economy to run differently.
We've seen the result of this in the past few years, with that oil turning itself into unsound credit, insured with insurers that, it transpires, won't be able to pay up if the bonds default. UBS, which a few months ago had $37bn-worth of such 'liquidity' pumped into the economy, suddenly realizes that the money is gone. Far from performing a function vital to the smooth running of capitalism, it was, in reality, transferring wealth from institutional investors in London to single-parent subprime borrowers in Missouri.
Whether that's a good or a bad thing is debatable. But there's little doubt that it isn't the kind of thing that UBS would cite as part of its positive contribution to the smooth running of capitalism.
++++
The UBS scenario is interesting because it raises an interesting hypothetical scenario. Many a political and (to their shame) economic commentator, appears to have assumed that there's a sequence of scenarios, each worse than the last.
Basically, if a bank gets into trouble, you go for a rights issue -- appeal to the investors to back you (see UBS). If that fails, then you look to be taken over at a cut-down price (see Bear Stearns). And if all of that fails, you look to the government to bail you out or take you over (see Northern Rock).
In other words, the worst case scenario is a government rescue.
This is all very fine if the financial institution is relatively small (e.g., Northern Rock, although even that is straining the Bank of England) or if the government is relatively large (the Fed). But what if UBS can't get a rights issue to work (even institutional investors have their limits) and can't find a white knight to take over its liabilities? There's no "state rescue" option here because, to be blunt, the Swiss National Treasury isn't that big. And you can hardly expect the American Fed to ride to the rescue of a Swiss bank.
In this worst-case scenario -- a bank which is large relative to the size of its domicile and is lalso a reasonable part ofthe global banking system — then you have the potential for a bank failure that could, indeed, cause some kind of systemic global financial crisis ('we've used up all the oil!!!!!'). What form that crisis would take and what its implications would be, I simply don't know, because we have never been in any situation that remotely resembles it. My guess would be that the world's banks would club together, take over the liabilities in bits and pieces, and the system would "muddle through". But a lot of people would suffer a lot of pain in the process.
_____________
