Crisis Blogging: Beware of the Doomsayers

Includes: IYF, SPY
by: Felix Salmon

Why blog about something as banal as a US recession when you can blog about a fully-blown financial crisis? Barry Eichengreen stays solidly in the realm of the hypothetical when he explains why any country's attempt to leave the euro would result in "the mother of all financial crises". He does mention Italy by name; he does not mention that Nouriel Roubini, last year, was already writing that "Italy may end up like Argentina" and end up exiting the euro within five years.

But Roubini has moved on from Italy and the euro, if not from crisis-blogging: he's now talking about the risk of a "systemic financial meltdown".

I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks...

Trust me, the list goes on.

What to do in the face of such doomsaying? A systemic financial crisis of the kind glossed by Eichengreen and Roubini is by its very nature almost unhedgeable. I suppose you could convert all your assets to gold, make a Jim Rogers-style long-term secular bet on the Decline of Western Civilization, learn Chinese, and move to Shanghai. Although that's not really a hedge, since you're basically taking off your long position entirely rather than just trying to protect yourself against a decline in its value. And besides, there's bound to be a good chance that you'll end up feeling as foolish as those people who sold everything and moved to the mountains loaded up with guns and water in the run-up to Y2K.

For what it's worth, I don't see a big bank-run happening, not in the US, if only because there's nowhere for people to put their money once they've removed it from the bank. In much of Europe and Latin America it's common to have offshore bank accounts; in the US, by contrast, it's extremely rare, partly because you have to pay taxes on your global income in any event. This is weirdly where fiat money comes into its own: because the dollar isn't backed by anything, it's hard to exit the dollar as an asset class.

A system-wide financial crisis isn't impossible, of course: almost nothing is impossible. Almost any financial downturn, taken to its logical conclusion, can become a crisis. But in practice, in the developed world, that doesn't seem to happen.