Allister Heath

Unintended market consequences

If only Alan Greenspan had read John Locke more attentively. The 17th-century philosopher, who doubled as a brilliant economist, was among the earliest exponents of the law of unintended consequences.

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If only Alan Greenspan had read John Locke more attentively. The 17th-century philosopher, who doubled as a brilliant economist, was among the earliest exponents of the law of unintended consequences. It is one of the most powerful lessons economics has to teach, yet one the former US Federal Reserve chairman conspicuously failed to heed.

To understand why hedge-fund whizz-kids have spent the past few weeks tearing their hair out, and why Greenspan is largely to blame, let us take a trip back to 1692. That year, Locke wrote with passion against a parliamentary bill that proposed to cut interest rates. Its supporters wanted to help the poor; but Locke realised that government intervention would be worse than doing nothing. Paradoxically, he argued, it would hurt hardest those it sought to help — ‘widows, orphans and all those who have their estates in money’ — by curtailing the supply of credit.

Fast-forward to 2001, the year in which Greenspan slashed US interest rates from 6 per cent to 1.75 per cent (they eventually fell all the way to 1 per cent). He was desperately and laudably trying to fight the twin effects of the collapse of the dotcom bubble and the fallout from 9/11. But while he succeeded beyond all expectations, staving off recession and covering himself in glory in the process, his actions also triggered a borrowing bonanza, a house-price boom and deeply imprudent attitudes to risk, laying the seeds of the current turmoil in financial markets.

Vast numbers of mortgages were extended to US borrowers with poor credit ratings, on the absurd assumption that interest rates would always remain low. Now that Fed rates are back up to 5.25 per cent, tens of thousands of sub-prime borrowers have started to default. At the same time, house prices in many poor areas have started to fall, cutting the value of lenders’ collateral.

It is not only those institutions foolish enough to have lent to borrowers who could never realistically be expected to repay that are being hit. Modern lenders never keep loans on their own books for long, preferring to sell them on to others. This is done by bundling large numbers of mortgages together into bonds called collateralised debt obligations (CDOs), which are subsequently sold to banks, pensions funds, hedge funds and other investors.

For years, credit rating agencies and others were convinced that CDOs were safe, with the risk of any individual default sufficiently diluted by the presence of many other, safer loans within the same bundle. But as more and more people have failed to meet their repayments, the value of CDOs has suddenly plummeted, exposing the naivety of many supposedly brilliant investors.

Many of the world’s most powerful institutions, from Goldman Sachs to Bear Stearns, are nursing massive losses, estimated at up to $200 billion globally. These could grow further as low, fixed-rate mortgage deals continue to expire and more Americans have to pay the market rate on their loans.

The worries soon proved contagious. Next to panic were investors who had loaded up on the cheap debt used to fund leveraged buy-outs. Worried by the possibility that all risky debt, not only sub-prime mortgages, may be more dangerous than previously thought, they took fright, leaving the banks that underwrite the big buy-out deals to take billions of pounds of debt on to their own books. This has led to the imposition by the banks of much more stringent lending conditions.

It is now harder to finance mergers and acquisitions, a development which threatens to halt the infusions of cash that have pumped up share prices and financed private-equity deals. Even more damagingly, it has become more expensive for ordinary companies to borrow money, even for routine investments. It has become harder to obtain new mortgages, even for borrowers on high incomes and good credit ratings, especially in the US.

In recent days central banks have stepped in, buying up hundreds of billions of dollars worth of bonds to inject liquidity into the markets. Their aim has been to prevent short-term market interest rates from surging and to ensure commercial banks are so flooded with cash that they can do little other than lend more. Pressure has also been mounting on Ben Bernanke, Greenspan’s successor as Fed chairman, as well as Bank of England governor Mervyn King, to cut rates.

Given that the global economy remains strong and no ‘systemic’ financial collapse is likely, that would be a terrible mistake. Interest rates should remain as they are; rewarding the markets for their over-exuberance would merely be to repeat Greenspan’s error of 2001. It would eventually guarantee an even more painful hangover.

Finally, to those newly unemployed fund managers foolish enough to have blown billions of other people’s money on doomed, high-risk investments, I have this to say: make use of your unexpected spare time to get better acquainted with the law of unintended consequences. It may help you earn a buck or two in the next bubble.