New book on the causes and effects of the credit crunch

On 5 February 2009, ‘De kredietcrisis voorbij?’ (meaning both 'Is the credit crisis over?' as well as 'Beyond the credit crisis?') was published by Noordhoff Uitgevers. In the book, eight financial experts, including Prof. Dr. Jaap Koelewijn and Dr. Eric Melse of Nyenrode, discuss the causes and effects of the credit crisis. Both authors talk about their contributions to the book.

According to Dr. Eric Melse, the book was written primarily for students of higher education and those with a general interest in what happened. Notwithstanding the rapid developments over the course of the credit crisis, it appears that many of the analyses and opinions provided by the experts are very informative and a good read. Melse: “We believe the content of this book will be relevant for a long time. At the same time, current events naturally play an important role. Therefore, at the website of the book many interesting case studies and exercises are published. The authors will continue to contribute material to the website to provide new insight and business cases.”

The forces behind the derailment
In one of the book’s chapters, Prof. Dr. Jaap Koelewijn searches for the forces that caused this “terrible derailment”.  Koelewijn proposes that the seeds for the current crisis were already sown in the early 1980s. “Interest rates and inflation were decreasing and the economy started to grow.” During the same period, the influence of shareholders began to increase. “They are being viewed increasingly as the most important stakeholders (in a company). I believe that something went wrong in this balance of interests,” he says.

The 1990s revealed a unique situation: labor productivity was climbing, production was increasing, wages were rising, but inflation was not. Koelewijn: “Because we started working more efficiently, room was created for interest rates to fall. And because of the lower interest rates and high profitability among companies, the equities’ markets witnessed tremendous gains. The prices of houses also started to rise. With the arrival of the Internet bubble, the system responded in an exaggerated, upward direction. After that, a crisis occurred. This remained limited to the financial markets, although a few significant blows were dealt and people lost a lot of money. After 2002 and 2003, this crisis within the financial markets spread to financial institutions. At that point, not only had a market crisis developed, but also a banking crisis. And this is where we are now.”

According to Koelewijn, the United States – the origin of the current crisis – is a country that is facing structural problems. “There is a huge budget deficit and a major current account deficit.” In addition to the bonuses paid to bankers, Koelewijn also points to a number of poor policy decisions, such as the enormous reductions in the interest rates implemented by the Federal Reserve. “These changes gave a gigantic boost to spending. The result was an increase in housing prices to a level that was completely out of control. The authorities were not willing to do anything about this.” The low interest rates and the pressure to spend, which originated with the American government, laid the groundwork for the problems. By this, Koelewijn means the process of extending credit, or making credit marketable, and the way in which credit was sold and the fact that people were able to take out mortgages 10 times larger than their annual incomes. “These are all results of a development which was set in motion earlier,” says Koelewijn. “In actual fact, the system is now in the process of digesting the excess, the large quantities of credit.”

 Flaws in the system
 According to Koelewijn, as a system, several structural flaws characterize capitalism. In his view  
 markets are, ultimately, unstable. “There is always a chance of derailment,” he says. “Within markets, financial
 institutions are intrinsically also a source of instability.” The instability of the system can, according to Koelewijn,
 be counteracted to some extent by supervising banks and financial markets, and by governments that take 
 regulatory action. “But this does not mean that you can never exclude  the possibility that something will go 
 wrong. Particularly when the government oversteps its bounds so significantly. And this is ultimately what
 happened with the lowering of interest rates.”
   
The demise of Lehman Brothers
The seriousness of the credit crisis became clear to everyone when the 158-year-old Lehman Brothers bank toppled. In the book, Dr. Eric Melse explores the question of whether or not it could have been clearer any earlier that the bank was getting into trouble.

He says that entrepreneurs and companies are measured on the basis of their quarterly results. “We owe a large part of the growth in our prosperity over the last 30 years to the extremely broad application of ICT across different areas of our lives. This has led to a continual increase in the speed with which we have access to information. As a result, managing companies on the basis of information has become stronger and easier. Thanks to the availability of this information, decisions can now be made and implemented within shorter and shorter periods of time. In the past, it took perhaps six months to put a decision into action, and it could have taken a year before you saw any results. If something went wrong, it would take another two years to make adjustments. These types of scenarios have been reduced to a quarter of the time – perhaps only a few months or less. Competition between companies now concentrates on very short periods of time. You could say that this is almost an operational perspective. I advocate that people try not to lose sight of the system perspective, or the long-term perspective. It is not true, for example, that those management teams that focus on the short term will automatically lead to the desired results in the long term.”

In addition to the short term, Melse also believes that it is important for management to think about structural changes. These changes require a structural approach in the way management guides the company. Melse: “Momentum accounting offers an alternative for looking at a company’s figures in a more structured fashion.” It can, for example, be used to calculate the growth in net worth during a certain period, on the basis of figures that are also used for the annual report. 

The question now is whether or not momentum accounting could have determined from Lehman Brothers’ figures that the investment bank was in bad shape any sooner than traditional methods. According to Melse, this does, in fact, appear to be the case. Whereas an analyst using classical performance criteria could have predicted that the bank would end up in difficulties no more than one year before the collapse, using momentum accounting, this could easily have been predicted up to two years beforehand. In his opinion, momentum accounting offers a useful supplement to normal financial information.

Beyond the crisis
So how do we recover from the crisis? According to Jaap Koelewijn, measures must be taken to ensure that the banking industry remains upright. “Attempts are now being made everywhere to do this.” He also advocates a more rigorous reorganization of the banking sector. “I think that the decision must be made to sweep all the ‘misery’ in these banks together and consolidate it into one institution, a sort of hive-off in which a new company is set up to take over healthy banking assets. This would result in a ‘bad bank’. The deposit account holders and the investors would then know exactly where the bad loans are. A necessary radical measure, as unpleasant and painful as it may be.”

According to Melse, the credit crisis is, to a large extent, a confidence crisis. “Money stands for mutual trust. The person who has it trusts that it may be spent. Conversely, if you deposit your money at a bank, you trust that it will still be there when you come back to collect it. The trust relationship that lies beneath the economic relationship has come under an incredible amount of pressure.”

The recovery of confidence is, according to both authors, also an important element in overcoming the credit crisis. Koelewijn: “We have to think very hard about how we are going to regain that confidence. More supervision, more protocols and more regulations are not the way to achieve this. I am convinced that they will not work. We have to work towards a situation in which financial institutions and companies clearly take responsibility for their actions, and stop constantly pushing the envelope. Otherwise, these types of situations will continue to happen. Regulatory authorities cannot prevent this. The forces in the market are too powerful for this. One way or another, the market will have to find a way to control itself.”

See also: http://www.dekredietcrisisvoorbij.noordhoff.nl (in Dutch)