The severity of the crisis was underestimated initially. Ben Bernanke, Chairman of the US Federal Reserve in March 2007 stated during Congressional Testimony: “At this juncture, the impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained.” In April 2007 US Treasury Secretary Henry Paulson delivered an upbeat assessment of the economy: “All the signs I look at show the housing market is at or near the bottom… The U.S. economy is very healthy and robust.”
The grande mal seizure of financial markets in September and October 2008, with the bankruptcy of Lehman Brothers, a large US investment bank and near collapse of AIG, the world’s largest insurance group, highlighted the seriousness of the problems. Since then national and international “committees to save the world” have implemented a bewildering and ever changing array of measures to try to stave of economic collapse.
The actions – dubbed WIT (“What it Takes”) by Gordon Brown, the English Prime Minister – have been focused on trying to stabilise the financial system and maintaining growth in the real economy.
Governments and central banks have moved to remove toxic debt from bank balance sheets, inject share capital to cover losses from bad debts and also guaranteed the bank’s own borrowings to allow them to continue to raise deposits and borrow. Bank of England Governor Mervyn King recently summed up the nature of the UK’s support for the banking system memorably: “The package of measures announced yesterday by the Chancellor are not designed to protect the banks as such. They are designed to protect the economy from the banks.”
Governments have provided large amounts fiscal stimulus and support for the housing market (in the US). In addition to the normal “automatic stabiliser” effects of reduced tax income and higher social welfare spending in a recession that push budgets into deficit, governments have launched new spending initiatives focused on infrastructure and direct payments to those most affected by effects of the GFC. Central banks have cut interest rates to levels not seen for decades.
It is not clear whether the actions taken will have the intended effect. As John Kenneth Galbraith noted: “In economics, hope and faith coexist with great scientific pretension“.
King Canute Addresses the Waves
The pretence of global co-ordination in policy responses, reiterated at increasingly frequent G20 summits, does not accord with the reality of individual actions.
Ireland’s anxious reaction to a “run” on Irish banks prompted a blanket government guarantee on bank deposits. This, in turn, led to a flight to Irish banks forcing the implementation of similar arrangements in other countries. The “electronic herd” did not notice that Ireland was guaranteeing deposits totaling over 200% of its own gross domestic production (“GDP”) calling into question its ability to honour these commitments if called.
There have been constant shifts in policy. TARP might well stand for Temporary Asset Relief Program (rather than its real name – Troubled Asset Relief Program) as there have been a succession of wholesale changes in the strategy.
The financial initiatives have not led to a significant easing of credit conditions. This reflects the fact that the capital provided is only sufficient to cover continuing losses but insufficient to restore normal lending and financial activity.
Money supplied to banks is not flowing into the real economy. Banks need funds to pay off maturing borrowings of their own as well support assets coming back onto their balance sheet (known by another three letter acronym – IAG – involuntary asset growth). Companies have also drawn down debt facilities, as their own financial position has deteriorated, requiring the banks to finance these requirements.
Governments and central bankers have become frustrated at the failure of policy actions to help the resumption of normal financial activity. Where governments have taken substantial stakes in banks, there is a noticeable drift to “directed lending”. Central banks and governments are increasingly bypassing the banking system and providing finance directly to businesses. The Federal Reserve may soon issue credit cards to all Americans under its own brand.
The debates miss the point that debtors still have too much debt and are not able to service it. Until the debt is written down and restructured, credit growth may not resume.
In the TARP Oversight Panel Report of 8 April 2009, Professor Elizabeth Warren observed: “Six months into the existence of TARP, evidence of success or failure is mixed. One key assumption that underlies Treasury’s …. approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth“.
The stimulus packages create different challenges. Well-intentioned infrastructure spending will take some time to have any meaningful effect. Skill shortages in key areas of expertise may slow down implementation. The need to avoid “leakage” where spending flows to overseas recipients in a globalised world is also paramount politically. The return on inadequately targeted infrastructure investment is also not necessarily high
Governments must also borrow to finance their spending. Many countries implementing fiscal stimulus packages already have large budget deficits and also substantial levels of outstanding public debt.
In 2009, governments around the world will have to issue US$3 trillion in debt. The US alone will need to issue around US$ 2 trillion in bonds (a staggering US$40 billion a week!). This compares to around US$400-500 billion of annual debt that the US has issued in recent years. This debt must be issued at record low interest rates.
China, Japan, Europe and other emerging countries have been major buyer of this debt. It is not clear whether they will continue to buy US government bonds, at least at previous levels. Wen Jiabao, China’s prime minister, provided a reminder of the importance of this issue in February 2009: “Whether China will continue to buy, and how much to buy, should be in accordance with China’s needs, and depend on the safety and protection of value of foreign exchange.” Yu Yongding, a former adviser to the Chinese central bank, recently sought guarantees that the value of China’s US$682 billion holdings of US government debt won’t be eroded by “reckless policies”. He asked that the US “should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way.”
At best, the tsunami of government debt may crowd out other borrowers exacerbating existing financing problems. At worst, there is a risk of a collapse of the growing “bubble” in government debt markets as investors refuse to purchase debt at current rates triggering additional losses. In January 2009, long-term interest rates moved up sharply as markets started to absorb the import of government initiatives. As James Carville, Bill Clinton’s campaign manager, once noted: “I want to come back as the bond market. You can intimidate everybody.”
Current initiatives resemble the “hair of the dog that bit you” cure where ingestion of alcohol is the treatment for a hangover. The current problems can be traced to high levels of debt accumulated by banks, consumers and companies. In effect, this debt is now being replaced by government debt. Simultaneously, the debt fueled consumption of consumers and companies is being replaced by debt funded government expenditure.
Adjustment in the level of debt and asset prices is part of process of through which the global economic system re-establishes itself. Governments and central banks can smooth the transition but they cannot prevent the necessary adjustments taking place. Like King Canute, central bankers and finance ministers cannot hold back the tide.
Multiplication by Zero
Like an athlete using drugs to enhance performance, the global economy used debt and financial engineering to enhance global growth. Increasing stimulus was needed to maintain performance in an unsustainable Ponzi scheme. The removal of performance enhancing drugs has exposed fundamental weaknesses.
A simple way to think about value in the global economy is in terms of Irving Fisher’s transaction equation:
Real Economy = Financial Economy
Real Economy = Quantity of Good times Price of Goods
Financial Economy = Money Supply times Velocity of Money
Quantity of Good times Price of Goods = Money Supply times Velocity of Money
The financial economy represents claims on the earnings and cash flows (both current and future) from producing and selling real goods and services. The financial economy consists of the money available and how rapidly the money can be circulated through the global economy (velocity). Banks provide much of the velocity of money in the economy through its borrowing and lending activities where a small amount of capital is leveraged to create larger amounts of money in the form of debt.
Recent economic prosperity was primarily driven by growth in the financial economy – increased money supplied by central banks augmented the rapid growth of and innovation of financial techniques within the banking system that increased the velocity of circulation. This increased the value of the real economy by increasing prices and also stimulating the expansion in the supply of goods and services.
The GFC has sharply reduced the financial economy, specifically it has decreased the velocity of money. As any student of mathematics knows anything multiplied by zero is itself zero.
The reduction in the financial economy necessitates a corresponding reduction in the real economy, initially in prices and ultimately by reducing the quantity of real goods and services. Falling prices of financial assets (claims on real goods and services) and, more recently, reductions in production volumes reflect the required economic adjustment process.
Government actions, however well intentioned, seem primarily to be based on the recognition that Ponzi or pyramid games are only bad if they end. All efforts are now seemingly directed at keeping the game going for as long as possible!
In 1976, James Callaghan, the Prime Minister, delivered the following grim assessment of Britain’s economic situation that is still relevant today: “We have been living on borrowed time. We used to think you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candor that that option no longer exists.“
Government actions, however well intentioned and significant, may entail pouring water into a bottomless bucket.
© 2009 Satyajit Das All Rights reserved.
Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).
This article draws on the ideas first published in Satyajit Das “Built to Fail” in The Monthly (April 2009) 8-13
One Response to “Second Lesson of the GFC: Whatever It Takes!”
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