A look at the next phase of the financial crisis

Summary

The global financial situation is complex and wreathed in fog, but at least two things are clear.

  1. The financial crisis consists of fore-shocks before the main event.
  2. A new geopolitical order will mark the solution of this crisis; it lies far in the distance.

This post examines the grim details of item #1.  Click on number two for that post.  There will be a long series of posts with good news on this site, but that time has not yet come.  But it will.

Quakes on Wall Street precede those on Main Street

Financial markets (”Wall Street”) are a virtual reality, in which millions of people react to events — and the results seen instantaneously on screens around the world.

In the real world (”Main Street) events move much more slowly.  People make decisions to hire and fire, to spend and to save, more slowly than decisions to buy or sell financial instruments.  Plans are made for periods of months or even years, and decision-makers (whether in households or corporations) only slowly change their thinking.  And the results of these decisions are only known after delays of weeks or months, and then often imperfectly through surveys.

The world is changing as deep subterranean forces move.  The effects were felt first by the financial markets.  The shock wave is just now hitting the real economy.  I suspect it will be as large as that which has devastated so many financial markets.

Do financial shocks cause real world recessions?

Much of humanity’s reasoning consists of post hoc ergo propter hoc — the logical fallacy of belief that what comes first must cause what comes next.  Since financial shocks tend to come first, they must cause the following economic shock.  Sometimes, but not often.  As we saw in the October 1987 stock market crash, which was a financial shock unrelated to any deeper event has little economic impact.

How large an economic quake should we expect?

Nobody knows, or can know.  We do not have the necessary data; what we have is only moderately reliable and available after long lags.  And the new world economy is too new, so that we do not yet understand its rhythms.

Also, this is the first downturn in the first global synchronized business cycle — that is, a cycle in which the majority of the world’s people participate.  Thanks to globalization and the spread of market-based systems, both the emerging world (most of it) and the ex-communist block participated.  Unlike previous cycles, everybody is slowing at the same time — there are no out-of-step locomotives to act as brakes.

My guess is that it will downturn will be long and deep.  Perhaps -1% or even -2% sometime during 2009 or 2010.  Global GDP has not gone negative since 1970 (there is not good global data before that).  During the major slowdowns – 1975, 1982, 1991, and 2001 — it never dropped below 1%.  Growth was unusally rapid during the recent expansion (almost an extraordinary 5%), and the downturn might be equally large.

That is what the crash in commodity prices suggests.  Oil from almost $150 to the $60’s.  The 60% crash in scrap steel prices (roughly $600 lbt to $250).  Likewise copper and the other industrial minerals, most of which now trade at prices below their marginal cost of production.

The massive foreshocks in the financial system have further destabilized the global economy.  Esp. the early October cardiac arrest of global financial system, which appears to have put an air bubble in the world’s bloodstream.   For example, during the past few weeks shippers have had difficulty obtaining letters of credit — interrupting to some unknown degree the normal flows of trade.  The collapse of the Baltic Freight Index tells the tale:

The Baltic Dry Index (BDI), the most closely watched measure of shipping costs for commodities, has plummeted more than 90% from its peak at 11,793 in May, caused by the sharp fall in demand for cargoes. The index tracking transport costs on international trade routes fell 47 points, or 4.1%, to 1,102 points on Friday, the 15th consecutive session of declines and its lowest level since September 2002. (source)

Mine is a far out of consensus position, with most economists forecasting 2009 global GDP between 2% and 3%.

Questions

All we have are questions about how the impact of the global recession on each region.

The most important question:  how will governments react?  The Great Depression was so great due to policy errors by governments.  The developed nations that suffered the most also made the greatest errors — the United States heading the list.  Let’s hope the new Administration shows greater wisdom than the Hoover Administration.


Originally published at Fabius Maximus and reproduced here with the author’s permission