Panic reaction causes widespread damage

An unfortunate feature of the discussion of the financial crisis is the tendency to blame greedy individuals for the problems. This is in contrast to discussions in the past when such difficulties were seen as more systemic.

More than ever before the responsibility for the crisis is pinned on individual “speculators” and “spivs”. To the extent that broader factors are blamed it is generally that the regulatory system has allegedly given too much leeway to such people.

This is also the significance of the frenzied debate about short selling. It does not seem to be based on objective analysis of how important that particular technique is in exacerbating volatility. Rather, it represents a moralistic attack on greedy individuals.

This assault on individual speculators spans the political spectrum. It is as much the domain of conservative politicians and commentators as it is of those who see themselves as on the left.

The problem with this view is that it mystifies what is going on. Rather than provide a rational explanation of recent developments it reduces them to a moral fable.

In fact the most striking feature of the contemporary financial markets is how they have been reshaped by risk aversion. As argued in Cowardly Capitalism, my book on global finance, in 2001 the financial markets have changed fundamentally in character. Whereas financial markets used to be primarily about acting as an intermediary for capital they have increasingly become a way of transferring risks. Developments such as the rise of derivatives and securitisation can be understood in this context.

This development has the paradoxical effect of diversifying risk in the short term while at the same time increasing the dangers of risk spreading. It means that individual lenders can, for example, reduce their risk by removing potentially problematic loans from their balance sheets. But if the loans do go bad it can spread a contagion effect far further than it would otherwise have gone.

This climate of risk aversion has also exacerbated problems in the markets more generally. Politicians have reacted in a panicky way and banks have become reluctant to lend to each other.

The contemporary culture of fear rather than individual greed explains the current crisis.