Musical Chairs: A Comment on the Credit Crisis

Uncertainty that is, a rise in unknown and immeasurable risk rather than the measurable risk that the financial sector specializes in managing is at the heart of the recent liquidity crisis. The financial instruments and derivative structures underpinning the recent growth in credit markets are complex. Because of the rapid proliferation of these instruments, market participants cannot refer to a historical record to measure how these financial structures will behave during a time of stress. These two factors, complexity and lack of history, are the preconditions for rampant uncertainty. We explain how a rise in uncertainty can cause a liquidity crisis and discuss central bank policies in this context.