Here an English translation of La machine infernale, my monthly column for March in Le Monde – Économie.
A DEVILISH DEVICE
Only five years ago, we were led to believe that the advertised model of the economic and financial apparatus represented a system that was finally mature: stable because thoroughly predisposed to self-regulate and practically safe thanks to super-efficient risk-spreading.
Self-regulation did not happen. Risk, although atomized, was nonetheless concentrated by the more astute players into enormous portfolios of financial products with, influenced by the economic climate, inflated risk premium; an unavoidable downside correction triggered the implosion of the Bear Stearns, Lehman Brothers, AIG, Fannie Mae, and Freddie Mac.
Computers brought complexification to the credit-based world of finances which from then on prevented it from functioning in anything but bubble mode: euphoria concealed the non-existence of self-regulation, while concentration of risk, for a time minimal, went undetected.
By contrast current events highlight the dysfunctional nature of the economic and financial workings outside the dynamics of an economic bubble. Thus, in the case of the speculation against the Euro, a collection of harmful elements combine in a potent toxic mix.
Sometime during 2001-2002, the European Union turns a blind eye to Wall Street’s currency swaps-disguised loans to member states in order to allow them to comply with the terms of the Euro zone Stability and Growth Pact (SGP). Yet, the increasing complexity of financial products makes it impossible for rating agencies to correctly assess the underlying risk. When the subprime crisis breaks in 2007, rating agencies are rapidly discredited. Vague attempts to reform those agencies suffer the fate of all proposed regulations at the time (with the exception of some, sufficiently innocuous): they are shelved into oblivion. Meanwhile, scientific rigor proving elusive, rating agencies will do with inflexibility.
The downgrading of Greece tainted currency swaps put them just a notch above the trigger for a margin call that that nation is unable to honour. Speculation on the, by now, strong likelihood of Greece defaulting gets under way. By taking long positions in Credit-Default-Swaps (CDS), speculators are “insuring” against a risk they don’t face, but by so doing, increase the likelihood that it materializes. Rising CDS prices, considered as an objective measure of risk, according to the prevailing “efficient market” economic theory, generate a proportional increase of the coupon required upon issuance of new debt by Greece, further penalizing her. A vicious spiral snaps in place that nothing can stop. Like so many dominoes, other Euro zone states are being lined up. Once one is in default, the rest of those still unscathed would be weakened, and speculation will immediately target the next most exposed.
When banks were failing, States provided help. The heat is now turned on States. Only the IMF will be left to stage a rescue. On February 26, an announcement was made, through its president, Dominique Strauss-Kahn that the IMF was ready to take up its role. We count on it: the IMF is surely the last defence line.
Many thanks to “bb”.