Tuesday, October 14, 2008

Economic Crisis - The Elements of Collapse are all in Place

Note Added Later: For US readers, there is a (slightly) more in depth discussion of the US bank nationalisations at the end. However, many of the points are the same as in my previous post on the UK...similar solutions, similar problems.

It seems that the US government is indeed going to follow the lead of the UK on bank nationalisation. In more news The Telegraph reports that the total (so far) committed to the bailout is in excess of £2 trillion (note for US readers, that is £GB!) if EU countries, the US and UK are added together. This is just the headline figure, and does not include all of the other measures that have been taken to increase liquidity. Meanwhile the UK stock market commenced a rally, only for the US stock market to pull the rally back down to earth. As I mentioned in my last (or a recent) post economic reality would bite into the false optimism. The Telegraph gives the reason for the fall as a slew of bad news from various companies, indicating that reality is just not playing to the script that governments would like:
US investors ignored comments from Mr Bush that the equity purchases were an “essential, short-term” measure and exhortations from Mr Paulson urging the banks receiving capital injections to use the funds to spur economic growth. Instead they focused on gloomy corporate news from soft drink group Pepico and software company Microsoft.
The reality is that economies are contracting, and no government action is able to stop the process. This from the Telegraph:
'World trade has already stalled. The Baltic Dry Index measuring freight rates for shipping has crashed by 82pc since May, touching a five-year low yesterday. Container vessels are leaving Asian ports with 20pc spare capacity. "We're heading into a global recession," said Simon Johnson, the IMF's former chief economist.'
No doubt, the tiny fall in the Libor (London Interbank Offered Rate - the interest rate at which banks lend to each other) will be taken as a positive sign, and will be hailed as evidence that the bank nationalisation is working. It is early days yet, but the tiny fall is a very poor result considering the dramatic action of nationalising major banks, and the cost of the bailout. Furthermore, even if the banks do start lending to one another, it will not stop the ongoing financial problems of the banks, which will see considerable worsening of their situation in the coming months (see previous posts). Once again, any growth in optimism will be short lived. I have said this many times, and it seems that others are nervous of the state of the banks, even after the bailout. For example the UK Treasury Select Committee Chairman:
'John McFall called on the rescued banks to provide much more detail of their exposure to derivatives and other complex assets, many of which have been plunging in value. He said: “It's a minefield we are tiptoeing through. That £37billion might not be enough.” '
However, there are those that think the financial crisis has come to an end:
If the history of financial crises is any guide, the violent credit shock of 2007-2008 has largely run its course. The sovereign states of the US, Britain, France, Germany, Italy, Spain, and Holland have broad enough shoulders to carry their load of fresh liabilities – even if Iceland does not.
This is a fascinating point of view, because the article goes on to say that phase 2 will see the damage to the rest of the economy. The delusion in such a view, I hope, is obvious. As the consumers default on personal credit, mortgages, and commercial borrowers go bankrupt, are the banks somehow going to be insulated? They have massive exposure to the state of the real economy (what else is there?) and, in many cases, have security in assets whose value is falling. The state of finance is linked to the rest of the economy and is not some island of activity. An end to the financial crisis? I think not - at best, a pause.

Meanwhile, the UK government finances are looking ever more threadbare, and the spending deluge into the public sector is being called to a halt. There are already discussions in government of lack of money being unavailable to follow through initiatives, as is detailed in the Times.
'A confidential presentation made to officials by Suma Chakrabarti, Permanent Secretary at the Ministry of Justice, detailed the savings required from the department 18 months after it was set up. They include the loss of 9,891 jobs in the prison, probation and court services – more than a tenth of the workforce – with one in three coming through redundancies. These cuts, along with a freeze on new recruits or the use of agency staff, could lead to the closure of up to 100 courts.'
No doubt, these kind of discussions are taking place within the US government as tax receipts fall, and costs rise. As I originally predicted in 'A Funny View of Wealth', as the government finances decline, there will be tough choices, and the shrinking back of the state sector will further ratchet down an already shrinking economy. The continued bailout of the financial system is likely to make borrowing for the government ever more difficult, and the crisis in government finances is just months away (I believe in three months time).

My guess is that, in the next couple of weeks, there will be a roller coaster ride of optimism, followed by pessimism, with stock markets continuing to swing in different directions according to changes in sentiment. As such, I do not think that too much attention should be paid to each swing, as it is not a reflection of any underlying economic reality, but dictated by emotional reactions to the situation.

Meanwhile, in the UK, an economist had this to say about the UK house market:
'David Miles, Visiting Professor of Finance at Imperial College Business School in London, said that the property market should stabilise once house prices lost 20 per cent of their value from the peak of the market last summer, which would translate as a further decline between 5-10 per cent.'
One wonders on what basis he has made such a calculation. Exactly what factors are going to halt the slide? Perhaps he knows some positive news that everyone else does not know about. I read another similar prediction from one of the banks, but have not been able to find the article. I have to ask, why are these people still taken seriously? I have even found an article that is suggesting that stocks are cheap at the moment, such that they are currently a good buy.

So now to pull all of these stories together. The first point to make is that, as I previously suggested, the first nationalisation is almost certainly just the start of the drain on government finances. The governments in the UK and US, as well as the rest of Europe, will need to be digging into their pockets on an ongoing basis in the coming months, including providing ever more money to support the nationalised banks. The cost of these bailouts is already simply astounding, and yet they so far have done very little to improve the situation, again exactly in line with what I predicted. Also, as expected, the governments are now starting to cut back, and the final downward levers in the economy are starting to come into play. In short, all of the elements of economic disaster that I predicted in a 'Funny View of Wealth' are now finally enacted. What I did not (and could not) predict were the actions of governments when the crisis finally came. Regular readers will be aware of my very negative views to all that has been done so far.

Now, at this early stage, in particular with the actuality of the bank bailout in the US mired in ineptitude and confusion, the full results of the bailout are not apparent. No doubt, when the US bailout eventually fails, it will be suggested that the problem was 'implementation' rather than the reality that it was never going to work. However, the effects of the bailout can be predicted in one respect, even at this early and confused stage. They will not work.

The real question is how long governments will continue to pour money into the financial system before the reality of failure sinks in? Or perhaps, it will be the creditors to the West who will call a halt by freezing lending? I am not sure which will come first, abandoning the effort or a forced halt. If I were a betting man, I would put my money on the latter.

I will continue to watch the unfolding of events, but may not post as often. As I have mentioned there may be swings of sentiment, and these are not going to be linked to underlying causation or changes in the situation. If I see something that does reveal something new, or anything which profoundly impacts on the situation, I will of course return to my keyboard. In addition, I have had some questions, and would like to answer these, if possible and time allows (apologies in advance if I can not manage this). For new visitors, I suggest a look at the links at the top left of the blog, which I hope will be more informative than just following a series of events. They will (I hope) give context and understanding of what is happening.


I have just been taking a look at the New York Times, which I do fairly regularly to get fresh perspectives from US (though it is on my secondary reading list). What I always seem to find is that the UK and US are running down parallel tracks, give or take some finer details, and small matters of timing. For example, today there is an article on the US bailout (no surprise there), an article on falling consumer spending, and even an article on a non-profit hospital unable to borrow (not quite public sector but....), and so forth.

As for the bailout, the major news, the NYT reports the potential cost of the bailout is put in stark terms as follows:
'All told, the potential cost to the government of the latest bailout package comes to $2.25 trillion, triple the size of the original $700 billion rescue package, which centered on buying distressed assets from banks. The latest show of government firepower is an abrupt about-face for Mr. Paulson, who just days earlier was discouraging the idea of capital injections for banks.'
The real costs will only become apparent in the next few months, as if these numbers are not enough cause for concern. Existing debt will likely prove far more toxic than imagined. The additional liabilities over the $700 bn spend are for guarantees for new debt. I have already detailed how any encouragement to lend from government is dangerous in a previous post, so the devil will be in the detail here, and that initial detail looks alarming:
'How would the government’s stake affect other preferred shareholders? Would the Treasury Department demand some control over management in return for the capital? How would the warrants work? [...] He [Bernanke] told the bankers that the session need not be combative, since both the banks and the broader economy stood to benefit from the program. Without such measures, he added, the situation of even healthy banks could deteriorate.'
In other words, it appears that the idea is that the banks must lend in the interests of the wider economy or 'wider good' (see my previous post for a discussion of why this is wrong headed). Once again, the parallel with the UK is clear.

An interesting point of difference between the UK and US appears to be that there is a more negative sentiment overall about the nationalisation of the banks, with even Paulson appearing to be (possibly disingenuously) apologetic. By contrast, in the UK, there seems to be more bovine acceptance of the situation, and the politicians pushing through the bailout appear to be enjoying their own sense of importance.

I will step out of more solid economics and speculate a moment. In this contrasting perspective, it is possible to discern an additional reason why the US might come out of this faster than the UK - a difference in outlook. In the UK there is a more firm belief that the government can 'fix' the problems, and that solution lies in the hands of government. In the US, there is more cynicism about the role of government and this is seen in the strong sense of unease about the bailouts. It may be that the US will turn away from magic wand solutions far faster than the UK. However, this is determined in the end by fickly politicians and public mood, as much as by circumstance.

On that note I will leave the post, and hope that the US readers will have some food for thought to the use of their tax dollars - bailing out banks and to be put to use in lending in the 'wider interest' of the economy. Can you imagine a more sure fire way to see money poorly invested?

1 comment:

  1. I just wonder. Maybe we are just looking too high at the chain. Creation of wealth depends on the definition of wealth. What is the price of gold if I have nothing to eat? Real wealth STARTS with necessities. We created a pyramid. But the pyramid stands on its base. How many farmers can go bankrupt before we starve? How many little people can become homeless before the pyramid collapses?

    Maybe we need an agricultural reform as well...


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