Wednesday, September 17, 2008

The Banking Crisis is as Much a Symptom as a Cause

It seems that my post on reform regulation will have to wait a little longer, so I apologise to regular readers who may have been waiting for the post. It seems that the news of the moment is worth further comment.

A good starting point is to refer you to some commentary in the Telegraph newspaper:
'In a year's time, consumers may look back on the past 48 hours as a bit like the first few minutes after the Titanic struck the iceberg, when high-spirited passengers played snowballs unaware of the danger they were in. '
It seems that people are finally waking up to the reality of the dire situation that we are in. The current banking crisis has arrived a little sooner than I expected (about one or two months earlier than I thought), and is actually just the start of the carnage. In a related story The Times today reports that unemployment has now reached a 9 year high, and with the highest increase since 1992. Once again, it is very much as predicted. The return home of Central Europen workers has acted as a dampener, but it could only slow the growth in unemployment so long. There is also a growing recognition that house prices have a long way to fall yet.

Following the Northern Rock fiasco, the first of the second tranche of UK banking problems is HBOS, with the government scrabbling around for a rescue package. I have not looked at individual banks closely, so I will not give a long list of those at risk. However, a good way of looking at the question of which bank is at risk is simply to ask which banks have seen massive growth in profits and expansion over the last ten years. Banks such as Royal Bank of Scotland come to mind, but I emphasise that I have not looked closely at individual institutions.

As if the fiasco were not bad enough, there are calls for the prevention of short selling of stocks (see here for a good description of what this means). This makes me think of the analogy of a person saying that they want to ban the use of thermometers for patients with a fever. It reveals the ignorance of those in power. The short selling is just an indirect indication of the underlying problems.

As for the whole idea of bailing out the financial system, I have suggested that government bailouts are not the solution. I am now ever more confident in that view. The reality is that the governments are just taking on liabilities from a stricken sector, and will then have to use the remaining healthy sectors of the economy to pay back the debt that they accept. Taking on such liabilities will also add to the coming crisis of government finances, as governments find that confidence in their ability to repay debt wanes, or collapses. They are, in other words, spreading the 'sickness' into other parts of the economy. Furthermore, where will governments stop, and how much can they bail out? The following makes the point:
'Fears that America's central bank – the Federal Reserve – may have over-stretched itself in agreeing to bail out AIG were underlined after the US Treasury announced plans to raise $40bn to allow the Fed to "better manage their balance sheet."'
Incidentally, the Economist reported a long time ago about the potential risks in insuring credit, but I am afraid that I do not have a reference for this (despite a quick search of the Economist site). We can expect more problems to emerge amongst the insurer and reinsurance companies.

The bail outs, I'm afraid, amount to a philosophy of 'something must be done', whether the something makes any sense or not.

In amongst the emerging realisation that the crisis is not going away, and the realisation that it will get much worse, there is no sign yet that anyone has yet realised that the banking crisis is not the problem. The mainstream economists, governments, and bankers still do not understand what is happening. The foolishness of the credit bubble has just been a mechanism of delay in the rebalancing of the world economy, putting off the inevitable restructuring of the world economy. There is no doubt that the credit bubble will have made what was always going to be a painful adjustment much worse. But it is not the cause of the problem.

For those who are new to the blog, I would suggest that you take a look at the recommended reading at the top left of the blog for an explanation of why the world economy needs to rebalance. The reasons are pretty straightforward, and blindingly obvious once you read them. The shocking thing is that none of the 'experts' seem to have grasped the nature of the problem.

The purpose of this post is, as much as anything else, to re-empahise that the banking crisis is not the real crisis. It is as much a symptom as a cause. It has taken such a long time to wake up to the fact that the economies of the OECD have been built upon foundations of sand, it makes me wonder how long it will take for everyone to wake up to what is the real cause of the problems. No doubt, for a long time yet, the symptoms will be confused for the cause.

Without understanding what the root cause of the problems might be, the solutions provided to solve the crisis will continue to be misguided. The UK, and other Western economies, can not afford to continue to try to navigate whilst blind.

What of New Zealand?

I had a comment from someone asking the prospects for the New Zealand economy. My apologies for the belated reply, and that I do not have time to find the original comment.

The answer is that, like the rest of the 'rich world' New Zealand will suffer in the current crisis, but there will be some countries that will feel the pain more than others. I do not know the New Zealand economy that well, (due to the size of the economy, it is not well reported on) but will hazard an opinion nevertheless (so treat what I suggest with caution). As a second apology I am rather pushed for time, so can only go on memory rather than checking facts and figures (so I reemphasise treating my comment with caution).

New Zealand has strengths and weaknesses. The first weakness is that, as the world globalises, scale of businesses will increasingly matter. New Zealand is just too small an economy, and lacks the large companies that will increasingly be dominant in the world economy. Another problem is that the New Zealand economy has a large tourism sector, and that this will be hurt by the current financial turmoil. However, this can be ameliorated by finding ways to appeal to new markets, such as China and India. The question is whether New Zealand can find an appeal that will resonate with these markets, and that is a question of marketing. At the moment New Zealand is very good at promoting itself as a 'clean green' location. The trouble is that the environmentalism that New Zealand loves may hobble other sectors of the economy, in particular agriculture and forestry.

As for the rest of the OECD, New Zealand has had a housing and credit bubble, but the size of the bubble is not as large as, for example, the UK. I have not looked in a long while, but I believe that the government debt is very high. and overall external debt, allowing for population and size of economy, is at a similar level to a country such as Germany (based upon a quick back of a cigarette packet estimation - please do not take this too seriously).

On the positive side of the balance, New Zealand has a large commodity sector, and this is a good thing in the world economy now, and in the future. Whilst commodities will have a bumpy ride, as the world economy swings wildly, the demand for commodities is, on balance, going to increase. Of particular note is the New Zealand agricultural sector, which has more potential than is currently realised. In particular, New Zealand has potential to develop a stronger food industry, and move up the value chain. If New Zealand is to realise this potential, they need to start to switch their added value food products to products that will service the Asian market. This will need a shift in the thinking of the people who run the large New Zealand food companies. The current milk scandal in China will not help matters much, but hopefully that is just a blip.

Overall, I think that New Zealand has the potential to fare relatively well, but I would like to reemphasise again that I speak from a position of relative ignorance.

Note for Lemming (a regular commentator on the blog):

Anatole Kaletsky still seems to have retained his job as a columnist, despite getting it all so wrong. He is still opining with complete confidence, and still seems to think he knows the answers. I wonder whether he reflects on his previous errors and suffers doubt? See his latest article here.

Note For Tin Hat:

Tin Hat, thanks for your question which I have edited and added below:
What are your views on how bad will it get. Lots are suggesting another Great Depression, that bad? Is there anything that can be done to protect your savings. On the basis of your assessment government bonds do not even sound appealing and gold buried in your back garden seems extreme! Your thoughts would be appreciated
Right now, I am afraid that I would be a very foolish person I were to be giving firm advice on where to invest. The trouble is that, in the short term there is no place of safety. The reason for this is that world economy is going to become more and more chaotic in the coming year. Much will depend on the actions of governments and politicians, and they are individuals who carry all of the faults of people anywhere. How will they react? So far, not very well. However, as the situation worsens, and the demands for action multiply, they will likely act upon their economies in increasingly irrational ways.

The other problem, at least in my mind, is what the instability will do to China. I have discussed this in another post, and the problem is that, if China's economy is pulled down enough by the turmoil, it is quite possible that the country will see civil unrest. The real question is whether China can sustain itself through the current turmoil, and I confess that I do not know the answer to that question. It is too opaque an economy to have any certainty. However, if the current crisis tips China into recession, then the world really will be in for a period of chaos, including civil unrest in China and the possibility of war as well.

As a general point I would suggest commodities, as they are likely in the medium term to gain in price, but holding commodities is not easy. I do not know enough about futures to know the maximum length of contracts, but suspect that they would not meet your needs, and would any case be too complex for most people. However, as the world economy absorbs the current blows, it will shrink back, lowering commodity demand in the short to medium term. I do not know what your time scales are.

As for putting gold in the garden, that seems as good a bet as any (just don't tell your neighbours). But seriously, as mindless as it is, gold does do well in periods of turmoil. The danger with gold is the very fact that it is a safe haven, and that means sentiment is the real driver of value. However, in the current climate, I can not see sentiment turning positive (on aggregate at least) for some time yet. However, I have to reiterate that, in the current situation, there really is no safe investment (there never has been, but I speak in relative terms). It seems that your instinct appears to be in accord with mine. Maybe you need to get out and buy that shovel (or spade if you are from Yorkshire).


  1. I have been following your blog with interest and your views strike a resonance that cannot be ignored. I have been advising people now that things are only going to get worse and its only a matter of time. Banks and governments taking out so much debt assuming the dancing would never stop....sheer madness. Worrying times ahead. What are your views on how bad will it get. Lots are suggesting another Great Depression, that bad? Is there anything that can be done to protect your savings. On the basis of your assessment government bonds do not even sound appealing and gold buried in your back garden seems extreme! Your thoughts would be appreciated

  2. Thanks Mark :) Yes, Fonterra is pissing in their pants right now :-O


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