Sunday, October 12, 2008

Every Man and Nation for himself

The root cause of the financial crisis is that private entities have come to believe that the inherent risk of their assets is higher than they had previously estimated. An increase in the perceived risk lowers the expected value of the asset. In essence, wealth has been destroyed simply because private entities perceive an increased risk to their assets. The way to solve the crisis is to help private entities lower their perception of the inherent risk of their assets. Unfortunately, chaotic self interest will almost certainly increase the perceived inherent risk of assets:

Iceland's prime minister, Geir Haarde, warned last week that it was now "every country for itself." This smacks of the financial autarchy that characterized defaulters in the financial crisis in Asia in the late 1990s. Similarly, when Argentina defaulted on its debt in 2001-'02, politicians there faced enormous pressure to change the rule of law to benefit domestic property holders over foreigners, and they changed the bankruptcy law to give local debtors the upper hand. In Indonesia and Russia after the crises of 1998, local enterprises and banks took the opportunity of the confusion to grab property, then found ways to ensure that courts sided with them.

Update: This article explains the point I was trying to make above about how value of wealth is lost.