Richard Feynman has claimed that “it is safe to say that nobody really understands quantum mechanics.” He was serious about it because of the complexity of the subject and the counter-intuitive consequences of the theory. Sometime I think that the global financial system is also beyond comprehension. But that is not quite true. Unlike quantum mechanics, the financial system is an artifact, albeit a very complex one. Also, it is possible to understand something and yet be unable to fully control it all the time. Once in a while, it can crash. When–not if–it does crash, you figure out what broke, fix it so that it does not break again, and get on with life. It will break again later due to a different bug but it will never be entirely bug free.

As I am an economist, I am supposed to understand the financial system. Luckily, I am not that sort of economist and so I don’t feel the slightest embarrassment admitting that I don’t have much of a clue. But sometimes I think that perhaps not too many people — even those whose business it is — have a clue either. Some suspect that even the chairman of the Fed, Ben Bernanke, too is not fully clued in. Go figure.

Anyway, I wrote a piece on the meltdown of the US financial system for MailToday. Why? Because everyone and his brother is writing one. So why not I? It will be in the papers tomorrow. But you, dear reader, get to read it today!

Atanu Dey’s Musings on the Financial Crisis

On September 10th, the Large Hadron Collider at CERN, went operational. The largest physics experiment ever built, the 27km-circumference accelerator took decades of planning, over a decade to build, involved 10,000 scientists from 75 nations, and cost $10 billion. For guiding particle beams, it uses over 1600 superconducting magnets, most weighing over 27 tonnes, cooled with 96 tonnes of liquid helium. On September 19th, a “quench” occurred that affected the magnets in one of the sectors and the LHC had to be shut down for repairs.

Critical failures can be expected to happen in any sufficiently complex system, whether mechanical or institutional. Though they are engineered by people, and therefore humanly comprehensible, the complexity can surpass human ability to fully manage and control them. This appears to be true of the global financial system which is a critical component of the modern global economic engine.

September appears not to be too good for complex systems. In September 2001, the US sense of invulnerability collapsed with the Twin Towers of the World Trade Center. This month’s spectacular near-meltdown of the US financial system is another collapse.

Whatever happens in the US happens on an unprecedented scale. Like its successes, its failures have global impact because of its disproportionate influence in the world. You cannot talk of the modern world without reference to the US. Practically every bit of modern science and technology – from bombs to computers – was developed there. It innovates and naturally so because 40 percent of the world’s R&D spending happens there. Seventy percent of the world’s Nobel prize winners work there, and is home to 30 of the world’s top 40 universities.

The figures one comes across in the reporting of the US financial crisis boggle the mind. The US Federal Reserve and the Treasury Department have asked for $700 billion to buy distressed mortgage-related assets. Add to that the $200 billion to rescue the mortgage guarantee firms Freddie Mac and Fannie May. Top it off with the loan of $85 billion to keep the giant insurance company American International Group afloat. The total assistance allocated to prop up the financial system so far – and it is anyone’s guess how much more will be spent eventually – is approximately the annual GDP of India, a country of a billion people.

All this spending by the US government will raise the public debt of the US to around $11.3 trillion. That makes it the biggest borrower in the world. The creditors, among others, are the central banks of many countries such as Japan, China, the oil-rich nations, and even India. Many countries maintain foreign reserves in US dollar denominated financial instruments. The US borrows approximately $2 billion dollars from the rest of the world every day. Why does the world permit the US to get away with it?

It is perhaps for the same reason that the US government is rescuing AIG, Freddie and Fannie: they are too big to fail. To recount briefly, there was a housing bubble in the US and it burst. With asset prices falling, there was a rush to sell assets. But if everyone rushes to sell, the prices fall. This leads to a downward spiral called a ‘debt deflation’. The housing bubble was created over years of easy money thanks to Greenspan, and subprime mortgage lending. The pendulum of market sentiment swung from the one extreme of greed to the other extreme of fear, as it always eventually does.

The financial system is a web of interconnected banks and financial institutions. AIG the mortgage insurer (assets of $1 trillion) cannot be insulated from the troubles of the mortgage guarantee firms Fannie and Freddie (combined assets $5 trillion.) They in turn are linked to other financial institutions globally and the contagion could spread unless action is taken urgently. Financial insolvency is contagious. By nationalizing Freddie and Fannie, and giving a bridging loan to AIG, the US government put a backstop to the slide. They were too big to be allowed to fail. But Lehman Brothers ($600 billion in assets) was allowed to go under because the collateral damage was manageable, and Merrill Lynch was sold. It was simply a matter of maintaining market confidence to arrest the domino effect of major institutions failing.

The US government rescued the US financial institutions it did because as noted before they are too big to fail. The US government is able to spend all that money it does not have simply because the US is too big to fail. The domestic financial crisis could have snowballed into an international financial crisis, the beginning of which would have been a crisis of confidence among the investors of the corporation known as the US.

It is said that if owe the bank a little money, and are unable to repay, you are in trouble; but if you owe the bank a billion dollars that you are unable to repay, the bank is in trouble. In the larger context, the US owes the rest of the world a lot of money. If it cannot pay it back, the rest of the world is in trouble. Therefore, the rest of the world has to make sure that the US never fails. That is why the US continues to get a massive line of countries credit –- often from relatively very poor countries such as China which has lent the US an estimated $2 trillion.

But it does not come without a cost to the US. Economists estimate that the financial crisis will cost it around two percentage points in GDP growth for the next couple of years because recession in the US is a given. Global economic slowdown is also guaranteed. As Niall Ferguson wrote in the Financial Times recently, it is not merely gloom but doom in terms of more shocks to the global economic system. The financial system cannot be isolated from the economic system.

Which is of course very depressing news for India because India any slowdown of the global economy will adversely impact India’s growth. India’s high technology sector income is tied to the US economy’s prospects. Global economic slowdown will have a major impact on the growth of emerging economies.

It is well to remember what Nietzsche said, “What does not kill me, only makes me stronger.” Financial crises, not unlike the problem with the collider, are not random. They are indicative of systemic problems. But in the final analysis, they are generally good because they force necessary changes. The complexity of the system had overtaken the ability of the regulatory authorities to manage the system. Now more thought would be given to regulations that work. The unreasonable success of the US is built upon a culture of innovation. The US will figure out a way out of this self-created mess and build a more robust system. The immediate effect of this financial turmoil will be short term pain but in the long run it would make the system less vulnerable.

In a few months time, both the LHC and the US financial system will be back up and running—at least till the next failure. You can bet your money on that.