This time, the problem was that the seemingly smart ideas simply didn't fail quickly enough. This was largely because they grew so fast. Credit default swaps--quasi-insurance contracts that, unlike real insurance, can also be used to make side bets on the likelihood of financial distress--are barely a decade old. When the dot-com bubble burst, they were a niche market. Yet last summer, the Bank for International Settlements estimated that there were almost $60 trillion of over-the-counter credit default swap contracts outstanding. (The market had doubled in size in the year preceding the credit crunch, June 2006 to June 2007.) Such astonishing growth exemplifies the exotic instruments that entangled a brave new financial system. By the time the vulnerabilities of the new ideas became apparent, they were large enough to take down the world's banks.
Next time, we're going to have to make sure that the next clever financial idea grows a little slower or is tested a little earlier. One way or another, early failures are better than late ones. As for the elite, I'm not too worried. They'll be able to find something useful to do--even if it isn't on Wall Street.
Wednesday, April 29, 2009
Good new article by Tim Harford in Forbes looking at the evolution of the market. It makes a good case for more regulation and a more graduate build up of financial innovation.