Stephen King: How Yossarian's philosophy could make us fly into a economic recession

A wonderful conversation neatly summing up some aspects of the current financial crisis takes place in Joseph Heller's Catch 22:

"From now on I'm thinking only of me."

Major Danby replied indulgently with a superior smile: "But, Yossarian, suppose everybody felt that way?"

"Then", said Yossarian, "I'd certainly be a damned fool to feel any other way, wouldn't I?"

And there you have the kernel of a market failure. The "best" outcome may not happen because each player's incentives lead to the madness of crowds.

Much of the debate that's taking place in the light of the current financial market turmoil completely misses this point. Some say that interest rates should be cut to save the wider economy. Others say that interest rates should not be cut – and some strange folk are saying they should still be going up – because those in trouble should have known better and now need to be taught a lesson.

But this is no longer a story about crimes and misdemeanours, and nor is it, directly, a story about economic weakness (notwithstanding Friday's very soft US employment numbers). It is, instead, a narrative about failed markets.

For the most part, markets work well. Sometimes, though, markets seize up. There may, for example, be a breakdown of trust. What happens then?

This, I think, is the key question to consider. Rather than thinking about who deserves to be blamed for the current mess, the most urgent thing for the authorities and banks to sort out is a return to normal market conditions. Otherwise, economic life may get very awkward indeed.

Although none of the participants are likely to see things this way – and nor are many outside observers – financial markets are, in part, public goods. Without them, there'd be no pensions, no linkages between household savings and industrial borrowings, no mortgages for house purchase, no ability to smooth one's consumption over a lifetime, and no nest egg for the future. Financial markets, therefore, matter beyond the profitability or otherwise of any one financial institution.

But financial markets are full of weaknesses. Some of these are admirably spelt out by Claudio Borio, who works in the Monetary and Economic Department of the Bank for International Settlements (otherwise known as the central banks' central bank.)

In Market distress and vanishing liquidity: anatomy and policy options (BIS Working Paper no 158, July 2004), Mr Borio talks about two types of financial market "limitation". The first is the inability to establish how systemic risk may evolve over time. Markets are risky because the past doesn't always guarantee the future, leading to the occasional outbreak of panic. Measures of risk exist, but too often they flash red only after the crisis has unfolded.

The second is the way in which incentives to take on risk are imperfectly established. As Mr Borio puts it, "...would it be reasonable to expect a bank or investment manager to trade off a sure loss of market share in booming market conditions against the distant hope of regaining it in a future potential slump? Or to refrain from retrenching during the distress phase simply because, if everyone behaves in the same way, distress can be mitigated?"

This herd behaviour is, of course, a common theme within financial markets. It exists because, although the outcome may be undesirable, the incentive for all participants is to act in ways that will hasten that outcome. It's a bit like going to a football match when the person in front of you stands up for a better view. You might then also choose to stand up. It won't be long before everyone is both standing up and worse off.

And that's what we're seeing at the moment. Trust has seized up within parts of the financial system.

One way to see this is through the rise in the interest rates banks charge to each other. Compared with the official overnight interest rates as set by the central banks, these "interbank" rates have gone through the roof.

Another way is to think about the different interest rates charged by banks for lending to the Government relative to each other. In the US, interbank rates are up at 5.7 per cent, whereas three-month Treasury bills are down at around 4.0 per cent (see charts).

Do these things matter? Admittedly, movements in interbank rates sound pretty esoteric, but they reveal a huge loss of trust within the financial system. There hasn't been a period quite like this in decades.

It's happening because although everyone now knows there's plenty of sub-prime toxic waste running through the system, no one's quite sure who has the big exposures, and as a result, no one wants to do business with anyone else.

Moreover, the crisis has revealed an element of reverse plumbing which has reduced the effectiveness of the liquidity injections from the Federal Reserve, European Central Bank and Bank of England. Traditionally, central banks extend liquidity to the commercial banks who, in turn, lend to non-bank financial intermediaries. Not this time. Over the past few years, banks have set up conduits and special investment vehicles which borrow from insurance companies and pension funds (through the issuance of very liquid commercial paper) to invest in more mature assets. But because these more mature assets are now, rightly or wrongly, tainted with toxic waste, the insurance companies and pension funds are no longer playing ball.

As a result, the conduits and special investment vehicles are coming back on to banks' own balance sheets. In turn, this means the banks have less money to lend to more traditional areas of business.

From this, it's not a big step to a full-blown credit crunch where even bona fide borrowers are unable to get access to funds.

George Akerlof won the Nobel Prize for economics for his insights into these market failures. He talked about the used car market. Every so often, a car is a "lemon" – in other words, its reliability is a lot worse than the average. Each seller knows whether their own car is a lemon, but would-be buyers do not. The buyers, therefore, will demand a lower price on all second-hand cars to compensate for the risk of buying the lemon. But if the price is now lower, those owners with the good cars may now refuse to sell. Following this logic, you soon end up with a tiny, illiquid, market full of rubbish. Most owners simply refuse to trade.

In the financial system, however, the situation is worse. The acidic juice from one lemon threatens to have a corrosive effect on the system as a whole because financial institutions are so closely interlinked. Policymakers, then, need to think carefully about how to deal with these financial lemons.

They could certainly cut interest rates, but then the lemons stay in the financial fruit bowl. Alternatively, they could choose to buy up the sub-prime debts and put them into a fund to be sold off at a future date (a bit like the Resolution Trust Corporation, a response to the 1980s Savings and Loans crisis), but that requires tax dollars. Perhaps, instead, they could choose to underwrite the value of asset-backed commercial paper, thereby tempting the insurance companies and pension funds back into the market and reducing the risk of a credit crunch, but again this creates a contingent liability for the taxpayer.

None of these responses is ideal. But policymakers need to ensure that steps are taken to preserve the financial "public good" because otherwise the industrialised world could plunge into recession.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com