At the end of January 2007, Jim O’Neill, head of research at Goldman Sachs, said: “Liquidity is there until it’s not there, this the reality of financial markets today.” A month ago on the Financial Times, John Gapper predicted the end of the current crisis in opposite terms: “Liquidity will return… just as suddenly as it disappeared”.
These two equally cryptic pronouncements are telling symptoms the difficulty in evaluating the consequences of the subprime quake: what’s hard is not locating the epicenter, but measuring its magnitude. Some can certainly exhibit the same sleepwalker awareness shown in previous financial crises, and saying this is just a “market correction” more violent than, but in the end beneficial. This is the position taken by Rodrigo Rato, head of the IMF.
But if we refuse to let reason lie, a question comes natural in response to the term correction: with respect to what? What’s the norm by which one can measure the extent and appropriateness of the correction? Only if they are shifts away from an equilibrium, can corrections be considered beneficial. But modern markets point toward a different truth. Liquidity suddenly disappears. If it didn’t, crises wouldn’t happen.
Since they happen, could liquidity turn out to be the risk’s doppelganger? O’Neill’s paradox could thus be rephrased as: “Risk isn’t there, until it reappears in uncontrolled, if not uncontrollable, ways.” This is possibly the lesson to be drawn from the present crisis: it’s different from previous ones not in terms of declared losses, or for its effects on the real economy, but for the impossibility of having its effects measured.
In the mid-1800s, Italian economist Francesco Ferrara wrote that “the void left over by a crisis is the best measure of the credit boom which had led to it”. Void can be a measure of wholeness, just as the crater left by a meteorite is a measure of its dimensions. But in our case the void was created by the traumatic re-emergence of risk, which was thought to have been globally dissolved for good, thanks to financial derivatives, similarly to a meteorite being reduced into fragments by its impact with the atmosphere, which engenders unthreatening falling stars. In a strange transmutation, risk comes back whole and dries up all liquidity from those financial instruments designed to ensure liquidity in markets. It’s a kind of risk that is not equivalent to the sum of its parts.
We had been told that lengthening the credit chain by securitizing subprime mortgages had allowed a further democratization of finance, giving access to markets to subjects hitherto excluded from the,. Perhaps what we are witnessing today is that such supposed advantage has been counterbalanced by a cost hardly measurable, since it affects the very nature of the debtor/credit relation. As an experienced debtor, Henry Miller, wrote: “Debtor and creditor are the same person”. This is because they share the same risk: neither one of them knows whether the debt will be repaid.
The dream of these years seems to have been that of a market in which creditors can avoid risk by simply apportioning it. It is often said that globalized finance is tantamount to atomistic finance. In finance, what is indivisible is the relation between debtor and creditor. The dream of an infinitely dividable risk thanks to the thousand paper assets offered by the market, leads to the possibility of reawakening and finding indeterminable phenomena facing us. The will to calculate all unexpectedly makes the incalculable apparent.
by Massimo Amato,
Institute of Economic History, Università Bocconi