The difficulty is that no one knows which batches of meat have been infected. If eating infected meat will cause the individual to become very sick, then the natural reaction is for everyone to immediately stop eating meat altogether. This will continue until the entire meat supply has been recalled and inspected. Subprime mortgage defaults were the E. coli that infected the financial system. Some mortgage assets would lose significant value as a result, but it was difficult to know which mortgage assets were “infected” and who was holding these assets. The natural response was to pull back from these assets. In a deposit run, when the quality of a bank’s assets is brought into question, depositors immediately withdraw their funds from the bank. In the case of the repo market, lenders raised the haircuts required for the repo loans or refused to roll over the repo loans collateralized by subprime mortgage assets. This is equivalent to a partial or a complete withdrawal of funds from the market by the lenders. 13 In addition, the higher haircuts forced the owners of the assets to come up with additional cash which typically meant that they were forced to sell assets. Given that there was little appetite to purchase mortgage-related assets, high-quality assets had to be sold in order to raise this cash. This put downward pressure on the prices of these assets and increased the uncertainty regarding their future values leading to demands for higher haircuts on these assets, as well.
I want to emphasize the word limited. Notwithstanding Adam Smith’s own reference to government intervention, the role of government must remain a limited one. If temporary market imperfections or difficult market adjustment periods give rise to the justification for relentlessly expanding the role of government, there will be a point when markets will no longer function effectively and when welfare creation will seize to advance. There is no better breeding ground for irresponsible behaviour than an environment of economic stagnation or worse, welfare decline. BIS Review 38/2005  1  There are times in history when the world economy undergoes fundamental structural change. With the rapid integration into the global economy of China and India, we are experiencing such historic change. Fundamental structural economic change invariably produces economic victims. The temptation for governments to interfere excessively with the free market is therefore particularly acute during periods when dramatic change occurs. Paradoxically, it is precisely then that the forces of the “invisible hand” are most needed to help bring about the welfare that can ultimately help absorb the negative externalities of change. If I am right that we are currently traversing such a period of historic change, it is more important than ever to ensure that government intervention in markets is limited and remains subject to continuous checks. Free markets under the rule of law, Ladies and Gentlemen, provide the optimal path to welfare creation and ultimately responsible behaviour by market participants.