The current economic crisis is comparable to that during the period before the great depression. It is interesting to see what got us to this state; the outlook for the world economy and what the appropriate measures are that can be taken to avoid a big L shaped multi year recession as was the case in Japan.
What are causes of financial crisis? What has been the impact?
It is clear that the cause of the current financial crisis has been the massive leverage that has been building up in the financial and the household sector for the past many years.
For a good number of years now the cycles of boom and bust have been around with each of these cycles creating and bursting bubbles bigger than the one before. Preceding the starting phase of each of these bubbles has been the drastic reduction of interest rates which created sufficient liquidity to channel money into creation of bubbles. In the late 90’s this resulted in the tech bubble that burst in 2001. In order to prevent a recession at that time, the policy response of the US Federal Reserve was to reduce interest rates and thus leading to the housing bubble. The household sector kept borrowing money to finance the purchase of houses and this led to massive run up of home prices. The US financial sector on the other hand packaged these mortgages into mortgage backed securities (MBS) and that into collaterized debt obligations (CDO). These are essentially complex financial instruments with illiquid markets currently that were wrongly rated AAA by the rating agencies and then were sold to markets around the world thus destroying transparency with all of them making a lot of money during the securitization. The world of finance is built on trust and once there is a lot of junk held by counter parties then no one knows as to the solvency of the party they are dealing with and thus creating a tremendous amount of counter party risk. When the best of the financial institutions like AIG, Merrill Lynch, Washington Mutual, Wachovia, Lehman brothers etc go belly up, there is a generalized loss of confidence.
The current crisis has also led to the demise of the shadow banking system, the ones that are not subject to regulation and was responsible for most of the financial intermediation in the last 20 years that could benefit from regulatory arbitrage. These include non-bank mortgage lenders, SIVs and conduits, broker dealers, hedge funds, private equity funds and money market funds. Most of these institutions have the features of regulated banks where they borrow short in liquid ways, most of them being heavily leveraged and then lending in ways that are illiquid or on a longer term.
In case of regulated banks, this maturity mismatch leads to the banks being considered fragile and the illiquid ones being subject to a run on the bank. To prevent this, the deposit insurance and the central banks were created many years ago which in addition to controlling inflation and growth in the economy, would also act as the lender of the last resort. In the case of the shadow banking system however, both the deposit and central bank’s lender of last resort role was missing thus making it a fundamentally fragile system as it was essentially a non-regulated system on steroids. The current financial crisis in short has been the unraveling of this mistake.
- The first step of this was the collapse of the non-bank mortgage lenders, like Fannie and Freddie, that engaged in sub-prime kind of lending and these went belly up when the toxic nature of those securities was understood.
- The next to go were the SIVs, like Cheyne, and conduits that were funding themselves with short term commercial paper and investing them into MBS and CDOs. The run then extended to the broker dealers with ones like Lehman brothers and Bear Stearns going belly up, other like Merrill Lynch having to get merged into a traditional bank like BOA and others like Goldman Sachs and Morgan Stanley having to be converted into bank holding companies being subject to regulation thus leaving no independent broker dealer left standing. This again was due maturity mismatch and their fundamental business model being flawed and during the crisis had to resort to the PDCF lending by the Fed thus needing regulation in terms of more liquidity, more capital, less leverage and more long term funding. The traditional broker dealer model no longer exists.
- The next to be affected were the money market funds as they had invested in toxic paper and the Fed had to intervene again to guarantee them with deposit insurance and thus get back into traditional ways of operation.
- The next to be impacted in terms of redemptions were hedge funds that had again borrowed short and lend long like the broker dealers.
- The private equity operators were the ones to be affected next due to the activities like leveraged buyout kind of activities when credit spreads were much lower and leverage ratios were very high.
In short the shadow banking system has essentially collapsed and the traditional banks have been severely weakened. Due to this seizure of banking there has been a lack of credit availability to the corporate sector with even the AAA rated ones being impacted. The Fed had to thus intervene in the commercial paper market as corporate sector could not raise the funds. The central banks thus instead of being the lender of the last resort has been converted to being lender of the only resort in this situation to the traditional banks, shadow banks and corporate sector and that is close to a systemic failure of the entire financial system.This has led to the stock markets crashing; inter bank spreads rising, money markets being shut down and the widening of credit spreads.
The policy response to be crisis has been coming on thick and fast but there is a growing disconnect between the actions taken and the market response. The 29 billion bailout Bear Stearns creditors and the creation of the PDCF in March 2008 resulted in a rally in the stock markets, money market and credit markets that lasted for 8 weeks into April and May. When Fannie and Freddie was deemed to fail and threaten the system in early and the treasury secretary Henry Paulson got the approval of congress to rescue them if needed, the markets rallied for 4 weeks. When the actual 300 billion dollar bailout had to happen in early September, the markets rallied for just 1 day with the US government taking on 6 trillion dollar worth on its balance sheet. The very next day there was a risk of Lehman collapsing and the following week was the 85 billion dollar bailout of AIG but the stock markets fell 5% that day. The following policy responses like the 700 billion dollar rescue package, the Fed paying interest rates on reserves thus massively being able to increase the support for financial system, the extend of credit by the Fed to the corporate sector for the first time since great depression, the coordinated interest rate cut by the Fed, ECB and other central banks has done nothing but a massive collapse of the stock market as the trust in the policy makers.
What is outlook for US economy (V shaped, U shaped or L shaped recession) and what are the possible fixes?
The scenario of a short 6-8 month recession is clearly out of the window. There is going to be a prolonged recession to go along with the financial and banking crisis in the US and the advanced economies. The emerging markets are going to also face recessionary pressures making this a global crisis.
What needs to be seen if the appropriate policy measures can be taken to avoid a severe multi year L shaped recession as was the case in Japan.
Several policy responses are in order according to leading economists. These include
- Additional policy rate cuts on top of the 50 basis point rate cut announced last week especially in Europe where at least a 150 basis point cut is needed. In the US the rates are already pretty low and a liquidity trap is to be avoided but a further 50 basis point cut is still in order to bring rates to 1%.
- Monetary easing alone will not be sufficient as the counter party risk still remains very high and so the interbank and credit spreads remain considerably higher than policy rates. There is a significant risk of run on the uninsured deposits in the banking system even after the limit in the US was raised from 100k to 250k as 2 trillion out the 7 trillion bank deposits in the US still remain un-insured and there are similar risks in other developed countries. At this point a blanket guarantee of all deposits is in order and even though this creates a moral hazard as in the S&L crisis where some took advantage of the situation to attract more deposits only on the basis of the guarantee provided.
- To prevent a moral hazard of blanket guarantee, the period should be limited to 6 months during which a triage of good banks needs to be done. Currently there are good and bad banks within the system that adds to counter party risk. The solution is to identify and injecting capital i.e. recapitalize the good banks and letting the bad ones fail. Creating more liquidity alone, as per the current TARP (troubled asset repurchase plan) will not be sufficient. Public capital should be used to buy preferred shares which would mean quasi nationalization of a good chunk of banks in the US and Europe. At this point there is no other alternative other than government ownership in the banks to continue providing credit. Matching contributions are required from existing share holders in terms on tier 1 capital and suspension of dividend.
- The ongoing liquidity measures such as the Fed stepping into the commercial paper market have to be continued.
- The bad debt of the banks also related to the debt in the household sector in terms of mortgage, credit card debt, auto loans etc and the consumer recession in the US would mean finding ways to reduce this debt burden and restore ability to spend like the HOLC plan during great depression.
- A massive fiscal stimulus is also needed to counter the falling aggregate demand, falling consumer consumption, fall in residential investment and fall in capital spending by corporate. Because of the recent events, corporate spending is likely to be subdued as the future is unclear and the cost of credit remains high. The involves massive public spending in terms of infrastructure, public works, grants to state governments etc to prevent a fall in aggregate demand.
- International coordination and is needed with support from international financial institutions like IMF, IDB etc to provide liquidity support to countries like Iceland that have been impacted by the crisis to act as international lender of last resort.
- The international imbalances will still need to be financed with the US going to run trillion dollar plus deficits in the coming 2-3 years. If the financing from the gulf, China and emerging markets do not come through then that would be a major source of economic re-balancing in the coming years. This will be unlike in the previous years where China used to vendor finance the US with the surpluses because the imports by the US is likely to come down substantially. International bargaining is still required to help US get over the purchase of the bad assets as per TARP.
Conclusion
The current economic crisis has shown that instead of de-coupling between the US and emerging markets, the real outcome has been a re-coupling. The initial effects of this were inflationary with higher commodity prices but the risk going forward is that of deflation. If appropriate policy responses are not taken then this could well turn out to be a long and deep depression.
References
http://www.rgemonitor.com/
Nouriel Roubini, Chairman, RGE Monitor and Professor of Economics, Stern School of Business, New York University
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