Wednesday, Jan 23, 2008
Bearish Economic Outlooks
Merrill Lynch: The Growing Global Credit Pandemic
Merrill Lynch: Many investors still believe that the credit crisis is purely a “US subprime problem”. Nothing could be farther from the truth, in our opinion. There appears to be a growing global credit pandemic.
Central banks only control the price of credit, and not the availability of credit. Watching central banks’ base interest rates is, of course, important. Watching credit availability is more important. I will paste an FT view by George Soros in comments.
Posted by happyrenterz @ 12:12 PM (1013 views) Add Comment
10 Comments
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1. happyrenterz said...
The worst market crisis in 60 years
By George Soros
Published: January 22 2008 19:57 | Last updated: January 22 2008 19:57
The current financial crisis was precipitated by a bubble in the US housing market. In some ways it resembles other crises that have occurred since the end of the second world war at intervals ranging from four to 10 years.
However, there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.
Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available. A bubble starts when people buy houses in the expectation that they can refinance their mortgages at a profit. The recent US housing boom is a case in point. The 60-year super-boom is a more complicated case.
Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy. That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former US president Ronald Reagan called the magic of the marketplace and I call market fundamentalism. Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves. Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalised and the US started to run a current account deficit.
Globalisation allowed the US to suck up the savings of the rest of the world and consume more than it produced. The US current account deficit reached 6.2 per cent of gross national product in 2006. The financial markets encouraged consumers to borrow by introducing ever more sophisticated instruments and more generous terms. The authorities aided and abetted the process by intervening whenever the global financial system was at risk. Since 1980, regulations have been progressively relaxed until they have practically disappeared.
The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility.
Everything that could go wrong did. What started with subprime mortgages spread to all collateralised debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion-dollar credit default swap market. Investment banks’ commitments to leveraged buyouts became liabilities. Market-neutral hedge funds turned out not to be market-neutral and had to be unwound. The asset-backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before. That made the crisis more severe than any since the second world war.
Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable. The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves. Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so. With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.
Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.
The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.
The writer is chairman of Soros Fund Management
2. hpwatcher said...
Very interesting; thanks for posting. Though, for the UK the situation is likely to be in multiples.
Good to see that someone has the balls to say that the west is entering a period of contraction...or recession.
3. happyrenterz said...
Another good article in the FT here. Comments on the role of Greenspan, gold standard...
4. japanese uncle said...
Central banks only control the price of credit, and not the availability of credit.
-------------------------------------------------------------------------------------------------------------------
Just having a glance at a few pages of the book titled "Princes of the Yen" by Richard A. Werner, will tell you that this statement is 'farthest from the truth', as far as the BoJ is concerned. The BoJ was powerfully manipulating the amount of credit via forceful 'window guidance' all through the years from the beginning of the bubble, up to the collapse of it. And I guess things are more or less the same elsewhere, in view of their stance as the honcho of the cartel of the powerful commercial banks.
5. submedia said...
fantastic post. thanks
6. confused76 said...
http://business.timesonline.co.uk/tol/business/economics/article3236663.ece
Merry King's speach in full.
It is four months since Northern Rock came to the Bank of England for support. And the headlines continue to be dominated by its fate. Northern Rock, however, is not the epicentre of the present global banking crisis. That lies in the very substantial losses made by many banks in the main financial centres as a result of the collapse of the US sub-prime mortgage market.
Those losses, and the fear of future losses on a wider range of loans, pose a threat to the ability of the banking system to finance continued economic growth — the so-called credit crunch. Concerns about the implications of a credit crunch, not only for the health of the US but for the world economy, lie behind the sharp falls in global equity markets over the past week. So the next year will pose economic challenges for all of us — more so than at any time since the Bank of England was given its independence in 1997.
Both industrialised and emerging market economies have been affected by the fall in asset prices but conditions vary across countries. It is striking that the banking crisis originated at the heart of the world's major financial centres. And the country most severely affected is the United States where the Federal Reserve today cut interest rates by 75 basis points — the largest reduction since August 1982 — to mitigate “increasing downside risks to growth”. The contraction in the US housing market has deepened and unemployment there is rising.
I want tonight to explain the nature of the challenges facing us and why many of them originate outside our shores. Exactly five hundred years before the Bank of England was given its independence, an Italian migrant who had made his home in Bristol, Giovanni Caboto, or John Cabot as he was known, set sail from this great city in May 1497 and became the first European to land on the North American mainland since the Vikings. A seafaring voyage like Cabot's is a good analogy for the challenges facing the British economy, which will have to navigate some distinctly choppy waters in 2008.
The challenge to the Monetary Policy Committee's ability to navigate our way through the next year reflects two strong economic winds; one from the west and one from the east. They correspond to what economists call demand and supply shocks. The former is the credit crunch which has blown across the Atlantic, and threatens a sharp slowing in output growth. The latter is the rise in energy and food prices, reflecting continued strong growth in Asia, that, together with rising import prices, threaten to lift inflation noticeably above target in the coming months. These two winds have stirred up the water through which the UK economy must pass.
The westerly gale first hit us in August as developments in the US mortgage market led to turmoil in global financial markets. For some years, banks were able to borrow cheaply in world capital markets to expand their lending. They packaged the resulting loans and sold assets backed by those loans to capital market investors. They were able to do that because some investors had failed to adjust to lower rates of return caused by high savings in emerging economies and low inflation at home. Those investors engaged in a ‘search for yield' by buying risky assets without always understanding fully the risks attached to them. Families and businesses had access to more finance at lower cost. That was most obvious in the growth of the US sub-prime mortgage market, where the potential problem of lending to people who could not repay when the interest rate was reset on their floating rate mortgages was becoming only too clear. In the United Kingdom too, borrowing and spending growth were strong and inflationary pressures built up.
But in August all that changed dramatically. Rising default rates in the US mortgage market led investors around the world to question whether they were being adequately compensated for the risks they were bearing on a wide range of assets - not just those associated with sub-prime mortgages. The prices of those assets fell, and markets closed for a range of complex credit instruments.
As I said two years ago, “risk premia have become unusually compressed and the expansion of money and credit may have encouraged investors to take on more risk than hitherto without demanding a higher return. It is questionable whether such behaviour can persist”. And, as we have seen, it hasn't. The re-pricing of risk that is still continuing is not a process that we should try to reverse.
Adjustment to this has been painful for banks in the major financial centres in two ways. First, with some asset markets closed, banks found funding more difficult. Some needed to finance loans they had made but had then expected to package up and sell. Others needed to finance off-balance sheet investment vehicles that were no longer able to fund themselves.
At the outset of the crisis, banks were concerned to protect their liquidity position. But increasingly, attention has turned to a second, more fundamental concern. As a range of asset prices fell, banks began to report large losses. Uncertainty about the scale and location of losses led to concerns about the adequacy of bank capital and hence the ability of the banking system to finance continued economic expansion. At the end of last year, sentiment in financial markets worsened markedly. So in mid-December, central banks around the world announced a co-ordinated set of actions in money markets. These were designed to boost confidence by demonstrating that we were conscious of the risks of a credit crunch.
Since those actions, conditions in money markets have eased considerably. The benchmark 3-month interbank lending rate has fallen by around 75 basis points relative to expected policy rates. But conditions are not yet back to normal and remain fragile. Although central banks can and will respond to the consequences of strains in the banking system for their economies, the solution to the underlying problem does not rest with them but with the banks and financial markets themselves. Banks must reveal losses promptly, and, most importantly, raise new capital where necessary.
But these developments in financial markets and the banking system have started to affect activity in the economy more widely. Interest rates charged to both households and companies have risen relative to Bank Rate, reversing the relative fall in the year or so before last August. And our own survey of credit conditions last month revealed that lenders intend to tighten conditions further this year. This tightening is unlikely to be short-lived.
Tighter conditions will discourage borrowing to finance spending on residential and commercial property, on business investment and on consumption. The impact on property prices is already clearly visible. Commercial property prices have fallen by 12% since the middle of last year. And, after rising sharply earlier in 2007, house prices stagnated in the final quarter. Although there is a considerable stock of equity in owneroccupied housing, with banks tightening the supply of both secured and unsecured credit, consumers will find it more difficult to borrow to finance spending. So in 2008 it is likely that a less buoyant housing market will go hand in hand with slower growth of consumer spending.
Tighter credit conditions mean that, as a nation, we are likely to save more of our income this year than in the recent past. In the short run, that will slow economic activity, possibly quite sharply. And there is a risk that weaker activity and lower asset prices could result in another round of losses for banks and a further tightening of credit conditions.
The adjustment which not only the British but the world economy is experiencing is necessary as the imbalances, between spending and saving and between domestic demand and trade, unwind. As part of a longer-run rebalancing of the UK economy, an increase in our national saving rate, both private and public, is necessary. The low level of national saving is apparent from the current account deficit — our new net borrowing from overseas — which in the third quarter of last year was, relative to GDP, the biggest in the past fifty years and the largest in the G7. It is possible to run a current account deficit for a considerable period. Australia, for example, has done so in every year since 1974. But our own position is becoming more difficult. For some years we have been able to finance current account deficits by borrowing, often through banks, at unusually low interest rates on world capital markets. Such borrowing is now becoming more expensive. Unless we spend less and save more, our current account position will deteriorate.
If we are to raise our national saving rate without overall demand, output and employment suffering in the medium term, we will need to export more and import less. Such a rebalancing is helped by the fall in sterling's effective exchange rate. Sterling has fallen, against a trade-weighted basket of currencies by almost 10% since August. And financial markets are pricing in a significant probability of a further decline in the exchange rate during this year.
A lower average level of the exchange rate can, by supporting overall economic activity, help protect us from the worst effects of the wind blowing across the Atlantic. But, by pushing up import prices, it will exacerbate the impact of the other wind now buffeting the UK economy, which comes from the east — the inflationary effect of higher energy and food prices. Strong growth of demand, particularly from China, India and other emerging markets in Asia, has been a key driver of the sustained rises in commodity prices over recent years, most notably oil prices.
Inflation has picked up in the industrialised world. It is now 3.1% in the euro area and 4.1% in the United States. And although consumer price inflation here is close to target at 2.1%, three developments now threaten to push it significantly above target this year. First, oil prices are around $90 a barrel, although they have fallen back in recent days. In August, the price was $70. Second, oil price increases have been accompanied by rising gas prices in wholesale markets. And this month we have seen announcements from suppliers of increases in household gas and electricity bills of the order of 15%. Third, world food prices have risen sharply as a result of strong demand growth on the one hand and poor harvests from South Australia to North Carolina on the other. Food prices on world markets are a third higher than they were six months ago, and that has been feeding through to prices in the shops. Food price inflation in our own Consumer Price Index reached almost 6% in December.
So 2008 is likely to see higher energy prices, higher food prices and, with a lower exchange rate, higher import prices, pushing inflation above the 2% target. It is possible that inflation could rise to the level at which I would need to write an open letter of explanation, possibly more than one, to the Chancellor. Although there is little we can do now to avoid some rise in inflation this year, the task of the Monetary Policy Committee is to ensure that it is short-lived. If inflation expectations were to pick up in the wake of a rise in inflation this year, then only a more prolonged slowdown would allow inflation to return to target. But if the rise in inflation does not affect longer-term expectations, then inflation could start to fall back towards the end of the year.
We are determined to keep inflation on track to meet the 2% target in the medium term. When the Monetary Policy Committee sets Bank Rate, it has to balance the risk that a sharp slowing in activity, by creating a margin of spare capacity, would pull inflation below the target, against the risk that, without such a margin of spare capacity, higher inflation in the short term might have a tendency to persist. So we face a difficult balancing act in the course of 2008. But we start the year from a position in which Bank Rate, at 5.5%, is probably bearing down on demand.
After a decade and more of a non-inflationary consistently expansionary (nice) economy, a phrase I coined in 2003, we moved to a somewhat bumpier but still rather stable path, which I described the following year as the not-so-bad period. You might think we have now entered a not-so-good period. To put it bluntly, this year we are probably facing a period of above target inflation and a marked slowing in growth.
Although we have little control over the strength of the economic winds buffeting our economy, our framework of inflation targeting does, as I said in my first speech as Governor almost five years ago, provide a seaworthy vessel. We cannot avoid some volatility in the short run and it is important that everyone understands the limits to the ability of central banks to smooth the economy. But, by keeping our eye firmly on the need to keep inflation close to target in the medium term, we can reach the calmer waters of low inflation, steady growth and a better balanced economy. And our policy framework will, I hope, allow you not to be overwhelmed by the headlines and to focus on what really matters for our future prosperity — the successful running of your own businesses.
7. Uh Oh Were In Trouble Something's Come Along And Its . . said...
I love this line :
"The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility."
IMHO there should have been a system in place where unfettered financial engineering innovation would have been temperered by a licensing system. Licences to trade in these new products would only be approved and issued by the regulators once and only once the product had undergone a thorough peer group evaluation, ensuring that catastrophies like the ones we're now witnessing from ever beginning.
The pharmacological industry is forced to ensure its products undergo thorough trials before being released; lest their products cause disability or death in the users. Yet the banks - it would appear - have been allowed to act with impunity resulting in the entire global financial body being infected.
(PS note to Dave Cameron and the meeja : I've just copyrighted these analogies so get your own. Just kidding. Go for it!).
(PS note to the conspiracy theorists : Have the Bilderbergers done it to themsleves?)
8. drewster said...
@happyrenterz, three excellent posts, many thanks.
9. Jc Wilson said...
"Central banks only control the price of credit, and not the availability of credit".
Much of the bank credit is sold on the private market, ultimately if a bank wants to create credit for a punter, he can originate it at base rate or above, however they must make it attractive to the credit maket to buy. Credit buyers are demanding high yeilds (interest) because they dont value the punters promise that they will pay back the principal if things get tough.... or indeed that the insurers will compensate them in that event... or indeed that the law will make them eat the loss rather than chasing the punter.
The actual problem (and why a 0.75% drop has only helped the DOW for a day) is that the credit buyers have, and continue to be burnt, they are not in a hurry to make the same mistake again. No one can force them to buy debt, especially at the lower rate of return that the FED announced.
This will continue untill the punters promise to pay is actually worth something. By then, dont be surprised of the bank will only lend you money if you keep the identical amount of liquid cash on deposit with them that they can have if you fail to pay their loan.
Hence the familiar addage (familiar to your Dad or Grand dad anyway)- you can only borrow money when you have it already.
10. paul said...
I read this on a lane to the Germanic fatherland this morning. Soros' summary of the current situation stands out as being unbiased and pragmatic.