Author: itsupport

The most notable innovations of the past two decades have been financial. Like technological innovation, financial innovation is concerned with the perpetual search for greater efficiency – in this case, reducing the cost of transferring funds from savers to investors. Cost reductions that represent a net benefit to society should be regarded favorably. But as the current financial crisis demonstrates, where financial innovation is designed to circumvent regulation or taxation, we need to be more circumspect.

Sadly, the financial revolution has been mostly rent-seeking rather than welfare-enhancing in character. It has been based on eliminating, or at least reducing, two key elements of banking costs closely associated with prudential arrangements.

One is the need for banks and other financial institutions to hold liquid reserves. The less liquid a bank’s assets, the greater the need for such reserves. But the yield on such reserves is small, so economizing on them is profitable. Last year’s Northern Rock debacle in the United Kingdom will long remain an example of how not to manage such risk.

Moreover, increasing a bank’s leverage can be very profitable when returns on investments exceed the cost of funding. Reckless balance-sheet expansion in pursuit of profit is kept in check if financial companies adhere to statutory capital requirements, which mandate a capital-asset ratio of about 8%. But many have sought to ignore this restriction, to their cost: the Carlyle Capital Corporation, a subsidiary of the United States-based Carlyle Group, was leveraged up to 32 times – it held one dollar of capital for every 32 dollars of assets – before adverse market developments wiped out the company.

Avoidance of prudential requirements is at the core of today’s financial crisis, exacerbated by the collapse of confidence in a system based on trust. This has exposed the fragility of the banking system, including quasi-banking institutions, as revealed by Bears Sterns, Lehman Brothers, and other US investment banks, and in Europe by Northern Rock, UBS, WestLB, and many more.

Perhaps the most tragic aspect of this story is the exploitation of low-income families involved in the so-called sub-prime mortgage crisis, whereby variable-rate mortgages were offered to customers with a low credit rating. In fact, “variable rate” is a misnomer, since these mortgages’ artificially low initial interest rates were pre-programmed to include a big rate hike after a couple of years. Thereafter, rates would rise with market rates, but never fall when market rates declined. This structure could only have been devised to suck in as many customers as possible with scant regard for long-term consequences.

With the property market booming, prospective capital gains promised untold wealth. And most mortgage holders probably expected to refinance their mortgages before their rising interest-rate trebled or quadrupled monthly repayments. Another hoped-for benefit was that capital gains could be converted into home equity loans, boosting homeowners’ living standards.

The rude awakening came when property values began to decline. For those without an equity cushion, refinancing was not a possibility, and rising interest rates have led to default, foreclosure, and homelessness.

Now we hear that sub-prime mortgage holders have only themselves to blame. No one talks of the bank manager, under pressure to sell “financial products” and eager to sign up customers, even if the products were not in a customer’s best interest. The banker did not question a bonus system that favors one year of super profits, followed by bankruptcy, over two years of moderate, but stable, results.

It is astonishing that sub-prime mortgages and their like were repackaged and resold in securitized form. That these collateralized mortgage obligations (CMOs, or bonds backed by a pool of mortgages) found a ready market, both in the US and abroad, reflects failure on several fronts.

The nature of these CMOs should have been apparent to risk managers. Any financially literate fund manager knows that risk and return are positively correlated. Any fund manager who claims to have been deluded by the apparently favorable risk-yield characteristics of CMOs or related credit instruments can be accused of having fallen for Milton Friedman’s “free lunch.” Risk models do not justify abandoning one’s natural sense of incredulity.

In a world where capital is free to flow across international boundaries, the crisis in the US has spread to Europe. This is a new form of contagion, which transcends national boundaries and is amplified by an international crisis of confidence. This is why the global problem today is many times greater than the Savings & Loan crisis of the 1980’s and 1990’s, which cost American taxpayers an estimated $150 billion to clean up.

Today, the global integration of financial markets means that problems can pop up anywhere, at any time. Central banks are currently attempting to plug one leak as the next appears. But if the financial system’s dykes collapse, we may be headed for a decade of severe deflation, rendering expansionary stimulus useless.

When the US Federal Reserve was created in 1913, its most important function was to serve as a lender of last resort to troubled banks, providing emergency liquidity via the discount facility. The current crisis suggests that this is no longer enough. Central banks worldwide are being forced to act as market makers of last resort in securities markets. The signs are already visible.

The European Central Bank has also failed to tackle local bubbles in Europe. The justification was that the ECB is concerned with inflation, not relative price adjustments. This means that monetary policy is geared towards the needs of large countries, like Germany, not to those of, say, Belgium. But, given the scale of the threat to Europe’s economy from a full-blown financial crisis, this apologia for inactivity has outlived its usefulness.

Copyright: Project Syndicate/Europe’s World, 2008.

The OECD sounded cautiously optimistic when it published its latest economic outlook in the middle of September. “Banks appear to have recognised most of the losses and write-downs related to sub-prime based securities,” it said. Yet within days, Lehman Brothers had slumped into bankruptcy protection, Bank of America had stepped in to bail our Merrill Lynch – buying it for about €35bn, half its value a year ago – and AIG was asking the Federal Reserve for a €28bn bridging loan.

That, of course, is the risk of making forecasts in such turbulent times. No doubt the irony of the timing was clear in Nice, France, where the EU’s finance ministers just happened to be holding a get together. At the top of their agenda: how to respond to financial turmoil and economic downturn.

The ministers decided to provide extra lending for small firms but ruled out public spending on the large scale seen in the US, which has spent €70bn on tax rebates in an effort to spur economic growth. The EU’s public lending arm, the European Investment Bank, is going to double the loans it makes available to small and medium-sized companies, which, because of the credit crunch, are finding it harder to secure finance from commercial banks. It will lend around €30bn over the next three years.

“We’re not simply adopting a ‘wait and see’ policy, we are not going to sit on our hands,” said French Economy Minister Christine Lagarde, who was hosting the event. “We need to make sure that our economies perform well.” Indeed they do, as the economic outlook for the Eurozone is bleak.

Inflation remains the policy priority, as ECB President Jean-Claude Trichet pointed at after the meeting. Soaring oil and food prices have pushed inflation up in the past year. The annual rate of Eurozone inflation hit a record four percent in July but has since eased a little after oil prices retreated from a high of more than €103 a barrel. The ECB has refused to reduce interest rates – which would encourage growth, but could also push up inflation. Its last move was to increase rates to 4.25 percent from four percent, on the grounds that inflation had to be tamed.

It’ll be interesting to see whether the ECB sticks to its strict line on rates. In April, the consensus view among policymakers was that Europe was not at risk of recession. With hindsight, that was hopelessly optimistic. Three days before the ministers got together in Nice, the European Commission cut its Eurozone growth forecast for this year to 1.3 percent from the 1.7 percent it predicted in April. It forecast growth of 1.4 percent for the broader EU group – including those, like the UK, that do not have the euro. That’s a big drop on the two percent it predicted in April. One reason for the change of heart is that, since April, gross domestic product in the Eurozone has shrunk – the first time the eurozone has experienced a quarter of GDP contraction since it was created in 1999.

Recession recession recession
That means the Eurozone is on the brink of a recession – it just needs another quarter of GDP shrinkage to fulfill the technical definition. However, the Commission is clinging to its optimism. It still forecasts that the overall Eurozone economy will stagnate rather than contract in the third quarter – although at national level it predicts that Germany will dip into a brief recession, followed by Spain and the UK.

Indeed, recession for some EU states seems now inevitable, even if its politicians refuse to use the word, for fear of making things worse (“Germany is not in a recession but in a downturn,” German Finance Minister Peer Steinbrueck told journalists in Nice).

Elsewhere, there is a willingness to face reality. Before setting off to Nice, the UK delegation had to digest a new economic forecast from the Confederation of British Industry, an influential lobby group. It said the UK would slip into recession in the second half of 2008 – albeit a “shallow” one – and that growth in the economy in 2009 will be the lowest since 1992.

It downgraded its growth forecast for 2008 from 1.7 percent to 1.1 percent and said economic output would shrink by 0.2 percent quarter-on-quarter between July and September, followed by a further 0.1 percent decline in the fourth quarter.

Its good news was that GDP should stabilise early in 2009 ahead of a gradual and growing recovery, with quarter-on-quarter GDP growth reaching a near-trend rate of 0.6 percent by the end of next year. Nevertheless, for 2009 as a whole, the GDP growth forecast has been cut from 1.3 percent to 0.3 percent.

Better news is that it expects inflation to peak at 4.8 percent this quarter, and thanks to an easing in commodity prices and the weaker economy, to fall back rapidly over 2009, reaching close to the Bank of England’s two percent target by the fourth quarter (2.3 percent). There is even a significant risk that, into 2010, inflation will undershoot the bank’s target.

This cheery view of the inflationary outlook should allow the Bank of England to make a series of rate cuts, bring the base rate down to four percent by next spring. “The bank should have leeway to cut interest rates and, as inflation falls, we should be well placed to move beyond this difficult stage in the business cycle,” said CBI director general Richard Lambert. “If all goes well there should be room for a half point cut in November to help restore confidence in the beleaguered economy.”

That’s if all goes well. “Over the past year our forecasts for economic growth have been shaved lower and lower as the UK economy continues to struggle with the twin impact of higher energy and commodity prices and the credit crunch,” Lambert added. “Having experienced a rapid loss of momentum in the economy over the first half of 2008, the UK may have entered a mild recession that will hopefully prove short lived. This is not a return to the 1990s, when job cuts and a slump in demand were far more prolonged. The squeeze on household incomes and company profit margins from higher costs will begin to ease as the price of oil moves downwards and, although the credit crunch will be with us for some time, conditions are set to improve later in 2009.”

Dark outlook
The CBI believes that UK unemployment will break the two million mark in 2009, reaching 2.01 million and a jobless rate of 6.5 percent. Average earnings growth is expected to remain subdued, which will aid the improving inflation outlook. Sharp rises in fuel and food costs, the resulting decline in real incomes and the troubled housing market have undermined consumer confidence and dampened household spending, and the CBI predicts that household consumption will contract by 0.3 percent in 2009.

Forecasts for investment have been downgraded, with fixed investment now expected to shrink by 3.5 percent in 2008 and by four percent next year, compared with flat growth predictions in the last CBI forecast. Much of this decline comes from the weak outlook for investment in buildings, as both residential and commercial property markets continue to struggle.

Is this relative optimism justified? The OECD’s global headline trends seem to be improving, but its forecasters are very cautious about making predictions right now. “Limited experience with some of the main drivers of the current conjuncture as well as uncertainty about some specific influences make for a particularly unclear picture,” it says, which roughly translated means: we haven’t seen anything like this before and we don’t want to come out of it looking like idiots.

Nevertheless, the OECD does venture that in the euro area and its three largest economies, as well as in the UK, economic activity is foreseen to remain broadly flat. More widely, Japan will see only a partial bounce-back and the situation in the US is still tough to call.

Globally, the OECD says financial market turmoil, housing market downturns and high commodity prices continue will continue to bear down on growth. “Continued financial turmoil appears to reflect increasingly signs of weakness in the real economy, itself partly a product of lower credit supply and asset prices,” it said. “The eventual depth and extent of financial disruption is still uncertain, however, with potential further losses on housing and construction finance being one source of concern.”

The downturn in housing markets is still unfolding, with reduced credit supply likely to add to the pressure. US house prices continue to fall, threatening further defaults and foreclosures that may again depress prices and boost credit losses. As regards construction, however, there are some hints of eventual stabilisation with permits and sales of new homes having ceased to fall and inventories of unsold houses coming down. In Europe, downturns in prices and construction activity appear to be spreading beyond Denmark, Ireland, Spain and the UK, with sharply lower transaction volumes a precursor of downturns elsewhere.

On commodities, the OECD notes that the price of oil has fallen from peaks reached around the middle of the year in response to slower demand growth and record production from OPEC. Oil supply conditions remain tight, however, contributing to volatile prices. Prices of other commodities – notably food – appear to have steadied at high levels. Food commodity prices may ease in the period ahead as droughts end in some food-exporting countries and as higher food production comes on stream.

On inflation, the OECD says that sharp increases in energy and food prices have boosted headline rates and sapped real incomes of consumers across the OECD area. Statistical measures of underlying inflation have also drifted up in most large OECD economies, partly reflecting the ongoing feed through of higher commodity prices. Wage increases have been broadly contained, so far. Its prediction: “If commodity prices are sustained at their recent, and in cases such as oil, lower levels some moderation of both headline and underlying inflation is to be expected.”

What should policymakers do in this tough climate? Pretty much what they are doing now, according to the OECD. In the US, underlying inflation is high but appears not to have drifted up further. The continuing credit crunch justifies Washington’s efforts to boost the economy with tax cuts. In the eurozone, underlying inflation has been rising steadily for some time, suggesting that capacity pressures need to be reduced, says the OECD. A recession would achieve that nicely, so there is no need to change policy. If action were needed, the OECD would rather see interest rate cuts than higher spending or tax reductions.

The message seems to be this: politicians and policymakers in the US, the eurozone and elsewhere have done all they can to avoid a deeper economic crisis. Now we just have to cross our fingers and wait.