Andreas Whittam Smith: Banks invite trouble if they try to reinvent the wheel

One way of seizing the significance of the banking crisis is to see whether it fits into the usual pattern of such events. To begin with, there must be a basic proposition that captures people's imagination. For example, the dotcom boom and bust had the potential of the internet as its centrepiece.

As JK Galbraith noted in his book A Short History Of Financial Euphoria (1993), speculation comes when popular imagination settles on something seemingly new in the field of commerce or finance. What was it that was seemingly new in banking that created the bubble that has resulted in famous companies having to write off billions of pounds of dud loans?

The answer is a bit more complicated than usual. A bargain was found during the 1990s and early 2000s which seemed to be the answer to many people's dreams. Savings institutions of various types could safely obtain a high rate of interest on their cash by lending to hard pressed home buyers in the United States and elsewhere through new types of securities created by the banks. Or, to put the matter from the point of view of purchasers of residential property: they could borrow on initially easy terms that deferred the day of reckoning.

The underlying assumption, however, was simplicity itself. That residential property prices would never decline. If they did fall, the bargain wouldn't work. In fact, home prices in the US during December were 6 per cent lower than a year earlier. In Britain, they are off one or two percentage points.

Alongside the basic proposition that creates the bubble, there is often found the delusion that some wonderful piece of financial innovation has been developed. This characteristic is now present. The "new" idea is a process known as "securitisation", which magically transforms bank loans into tradable securities. But Galbraith was surely right in arguing that "what is recurrently described as financial innovation is, without exception, a small variation on an established design". And he added: "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version."

So it is with securitisation. This is essentially banking – that is, borrowing short to lend long – but not acknowledged as such and conducted along 19th-century lines where there is no regulation to ensure the holding of sufficient reserves to meet withdrawals. The innovation turns out to be a wobbly wheel.

The creation of the bubble is sustained by an invincible self-belief. Again I quote Galbraith: "No one wishes to believe that the boom is fortuitous or undeserved. All wish to think that it is a result of their own superior insight or intuition." The euphoric episode is protected and sustained by the will of those who are involved in order to justify the circumstances that are making them rich. This is why the opinion of market participants regarding the development of the crisis are worthless. They invariably give an optimistic appraisal, relying on the rest of us to bow to their experience. We can read their self-justifying comments every day in the financial pages of newspapers. Their dirty secret is that they do not posses superior knowledge.

I am afraid the economists are not much better. They rely on financial models that have difficulties in capturing bubble conditions. Wisdom will be found, if it is to be found at all, from those possessed of well informed intuition. George Soros, 77, is an example. He has been a gifted participant and he also knows some history. His views received some prominence last week when he commented that the world is facing its worst financial crisis since the Second World War.

"The current crisis is not only the bust that follows the housing boom," he said. "It is basically the end of a 60-year period of continuing credit expansion." Finally, the bubble bursts. Euphoria is replaced by gloom. History records no case where the bubble gracefully deflated, accompanied by a slight hiss of escaping optimism. The speculative episode always ends with a loud explosion. Have we had the climactic event? One candidate is the crisis that recently engulfed major American banks such as Citibank and Merrill Lynch. They revealed unprecedented losses on mortgage backed securities, expelled their chief executives, and brought in fresh capital from Asia and the Middle East. Is that climactic enough?

Or did the bubble burst last week with the big break in stock markets on Monday and Tuesday, magnified by the closing down of the trading positions of Société Gé*érale's rogue trader? I think not. My guess is that this last piece in the jigsaw puzzle has still to be put into its slot. The pattern of boom and bust is not yet complete.