Since 2007, the Western economies have been shaken by the near collapse of financial markets. Huge losses have been incurred affecting individuals, corporations and nations in a way not seen since the depression of the 1930s. The banking industry is on the point of collapse in a number of countries. Credit is constrained, there is little economic growth and confidence is in short supply. Trust is a thing of the past. The threat of unemployment is real for a growing number of people.
Why? Because the western world lived beyond its means for too long, and because individuals indulged themselves with easy access to cheap credit. On top of that, the financial services industry ignored the basic laws of prudence and common sense, and regulators did not intervene.
How did it happen?
Governments ran up ever-increasing deficits and, consequently, national debt levels soared as a result of sloppy or populist policies, driven by the need to be re-elected. Citizens seldom demand higher taxation or refuse handouts.
Individuals had easy access to credit for consumer goods and housing, and were encouraged to splurge on, for example, buy-to-let properties. Individuals felt property prices would only rise and the sooner they purchased, the better--else they would be left behind and lose the opportunity to make a killing. Their ability to borrow went out of sync with their capacity to service the borrowings. The advent of the euro created a vast supply of historically cheap credit and poured petrol on an already blazing fire.
The financial services industry facilitated the increasing provision of consumer credit, and in pursuit of volume and market share banks competed in the provision of mortgages. They loosened their lending criteria and, in some cases, used brokerages whose practices were dubious.
To create the capacity to lend, banks securitised groups of loans, sliced and diced them into packages, had these rated by the rating agencies and sold them on to other institutions. This in itself is not a problem--until the slicing and dicing becomes ever more complicated and people fail to understand the underlying risk to which they are exposed.
It's a problem when rating agencies apply a formulaic approach and don't address basic questions of likely default in particular scenarios.
It's also an issue when one part of a finance house bets on the default of a security initiated by another part of the same house but sold on to third parties.
When buyers depend solely on a rating to make investment decisions, rather than understand the instrument they are buying, It's also a problem.
The industry focused on sales rather than risk. Participants forgot their job was to facilitate trade and industry, and became players themselves.
Many banks' balance sheets became stressed as the relationship between deposits and loans deteriorated, and reliance on short-term market funding grew. Some banks proved adept at moving positions off balance sheets.
Meanwhile, the regulators and central bankers said very little. Everybody talked about growth. Nobody noticed the temperature rising before the inevitable burn-out.
The values of any non-cash assets individuals own have been reduced.
Pensions, both personal and corporate, were badly hit. As a result, people close to retirement have suffered both reduced asset valuations and increased cost of annuities. Deficits are common in many corporate schemes and employers are unable to restore the reserves to the correct level.
Anybody dependent on the state for their pension is aware that it has not funded their rights and expectations, and that it wants to reduce its liability.
Credit has dried up as banks have had to reduce the size of their balance sheets, lost confidence in their banking counterparties and become reluctant to lend except for short periods. …