more economical woes ahead

Nobel prize winners warn financial system is still not out of the woods

By Ambrose Evans-Pritchard,
International Business Editor, in Lindau, Germany

1:27am BST 22/08/2008

A top caste of Nobel Prize economists has warned that the world's financial system may not start to recover for at least another year, leaving banks at mounting risk of an insolvency crisis.

"There is a tremendous amount of de-leveraging still necessary in the United States and Europe," said Myron Scholes, the father of complex derivatives.

"I'm not exactly sure when it's going to end. There are many financial institutions that need to add capital or sell assets, but it's getting more difficult," he said, at the annual gathering of Laureates on Lake Constance hosted by Sweden's Riksbank.

Mr Scholes, co-founder of the hedge fund Long-Term Capital Management, has had a brush with a systemic melt-down. His fund was almost $100bn (£53bn) underwater in the 1998 financial crisis after Russia's default caused bets on Italian and Spanish bonds to turn bad. The US Federal Reserve came to the rescue by slashing interest rates.

Joseph Stiglitz, the former head of the White House Council of Economic Advisers, said the crisis would cost the US $1.5 trillion over the next three years. But this is just the start. The downturn is engulfing most of the global economy.

"This has spread to Europe, and will probably spread to China," he said.

He said the European Central Bank was making a serious error trying to squeeze inflation. "There is no theoretical justification for this," he said.

"They seem to have recognised that there are other risks beside inflation, so there is a glimmer of hope," he said.

"A lot has changed since the wage-price spiral of the 1970s. Labour unions are weaker, and globalisation acts as discipline on wage demands," he added.

Mr Stiglitz said the watchdogs had failed to prevent the credit bubble because they were themselves captives of ideology. "There was a party going on and the regulator didn't want to be a party pooper. They encouraged people to take out floating-rate mortgages at 1pc."

"Banks didn't just fail to manage their credit risk, they created credit risk. We have to bear the consequences," he said.

He cautioned against a punishment policy that would further damage the banking system, saying it was Japan's refusal to bail out the banking system in the 1990s over fears of moral hazard that led to the protracted slump.

Mr Scholes, an unrepentant free-marketeer, said governments had been a key cause of the debacle.

"It is necessary to remind people of risk. I hope there is not a rush to regulation, because the costs might be higher than the benefits," he said.

Moves to restrict lending by the mortgage giants Fannie Mae and Freddie Mac six years ago are a textbook case of what can go wrong. Other lenders operating outside any normal restraint muscled in on their once stodgy home loan business.

Berkeley Professor Daniel McFadden said the crunch was now moving into the broader economy, threatening a number of companies with bankruptcy.

He said the disastrous errors of recent years bring into question the whole assumption of "market efficiency" that lies at the core of modern economics.

He proposed a body like the US Food and Drug Administration to certify new types of securities and derivatives.

But at root, the failure is one of moral care. "Amid a rush to profit, what's been lost is the idea that a banker has some responsibility to protect the client's interest," he said.

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