Wednesday, July 22, 2009

We should be so lucky to have a double dip

The global crisis of 2008-2009 was abrupt, rooted in the financial markets of advanced countries where it went through synchronised stages that sometimes can be pinpointed to the day, then spreading to the real economy in different ways, timing and speeds in different countries. It is a seismic crisis as deep – so far – as that of 1929-32. In the end it may turn out to be shorter, and therefore less deep than that, thanks to the more appropriate, large scale and synchronised – also so far – policy responses by world governments and international financial institutions.

The suddenness, financial origins and stages of the crisis are best synthesised and illustrated by the evolution of Interbank Market Spreads, i.e. the difference between 12-month Euribor/Libor and Overnight Index Swap rates, in basis points (from “The ECB Enhanced Credit Support”, a keynote Address by the European Central Bank President, Jean-Claude Trichet, given on 13 July 2009 at the University of Munich; Figure 1 below).

Figure 1
All was well in the euro, sterling and US dollar markets until August 2007, the “Beginning of the Turmoil”, when the US crisis of subprime mortgages erupted. The Turmoil worsened gradually until September 2008 (on 15 September, Lehman Brothers went bankrupt) when it began to intensify reaching a peak in November 2008; the spreads have declined gradually since then but are still as high in July 2009 as they were around July 2008.

It is best to let Jean-Claude Trichet speak: “…we have to acknowledge that there was a dramatic shift in focus in large parts of the financial sector – away from facilitating trade and real investment towards unfettered speculation and financial gambling. Hans-Werner Sinn has called these deviations “ Kasino-Kapitalismus”. Of course, we all know that financial liberalisation and financial innovation have made important contributions to the overall productivity of our economies. The securitisation of loans, for example, had tremendous potential for the diversification and efficient management of economic risk. But securitisation was implemented in a precarious way. Banks and non-banks were able not only to sell loans, but also to place them fully off-balance sheet as soon as they had been granted. This resulted in weak underwriting standards and a lack of incentives for lenders to conduct prudent screening of loans. “ …

“The credit boom leading up to the crisis was exacerbated by three multipliers:

- first, incentives: ill-designed compensation schemes for loan managers and traders that reinforced the shortening of their time horizons;
- second, complexity: increasingly complicated and opaque financial instruments that made it difficult for holders of securities to assess the quality of the underlying investments; and
- third, global macroeconomic imbalances: a chronic shortage of savings in some industrialised economies was made possible by an excess of savings in other parts of the world."

"In mid-2007 the turmoil erupted. This was sudden, but not entirely unexpected. Indeed, as long ago as January 2007, I myself expressed the views of my fellow central bankers, when I indicated that markets would need to prepare for a general reassessment and repricing of risk, which was clearly underestimated at that time. [1] Some months later, this repricing occurred very suddenly, triggering turbulences in the interbank market. The consequences of this very sharp repricing threw the credit boom into reverse. The asset cycle turned, and many of the missing links in the financial chain were exposed.

The collapse in mid-September of last year of a major financial institution [Lehman Brothers] transformed the financial turmoil into a global financial crisis. Immediately, financial intermediaries restored liquidity buffers, scaled down their balance sheets and tightened lending conditions. They dramatically reduced exposure to the risks that they had imprudently accumulated during the period of financial euphoria. Collectively, they engaged in a large-scale “deleveraging” process. Banks’ intermediation was sharply reduced, and loans to companies were curtailed.

A long-term trend that had brought credit risk spreads on loans extended by international financial intermediaries to historical lows was suddenly reversed. A credit squeeze ensued which took a severe toll on the real economy.”

Barry Eichengreen of Berkeley and Kevin O’Rourke of Dublin have tracked down the course of the current crisis against that of the 1929-32 global crisis, in terms of industrial output, Stock Exchange values and international trade volume ( 6 April, updated 4 June 2009). They have taken as the respective starting points of the two crisis the earlier peaks in world industrial production, which occurred respectively in June 1929 and April 2008. Month after month, our current recession replicates the trends of 1929-32 or is worse. Signs of improvement appeared in the 9 June update, but do not alter the basic picture: the latest levels to which our recession has plunged in 2008-2009 are still below the corresponding levels reached at the equivalent time in 1929-30. “Today's crisis is at least as bad as the Great Depression” (cit). See Figures 2-4.

Figure 2. World Industrial Output, Now vs Then (update in green)

Source: Eichengreen and O’Rourke (2009) and IMF.

Figure 3. World Stock Markets, Now vs Then (update in green)

Source: Global Financial Database. From: Eichengreen and O’Rourke (2009)

Figure 4. The Volume of World Trade, Now vs Then (update in green)

Source: League of Nations Monthly Bulletin of Statistics. From : Eichengreen and O’Rourke (2009).

This “trade destruction” appears to have been much worse than in the corresponding months of 1929-32; it is one of the most worrying aspect of our recession. As recently as May 2008 the IMF External Relations Department could still issue a paper “Globalization: A Brief Overview”(“By IMF Staff”), saying that “Globalisation is irreversible: In the long run, globalization is likely to be an unrelenting phenomenon” (italics in the original). Six month later an important episode of de-globalisation was already under way.

To sum up, – Eichengreen and O’Rourke conclude – globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The “Great Recession” label may turn out to be too optimistic. This is a Depression-sized event. That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline.”

The hope is that the massive macroeconomic intervention jointly set in motion in particular by the G-20 of April 2009 but also before and after, eventually will reverse the course of our recession. Monetary policy has responded faster and more strongly in the present crisis: in 7 major countries interest rates have been cut more rapidly, from a lower level, down to unprecedented low levels. In 19 major countries money supplies in the run up to the beginning of the current crisis had been growing faster than before 1929, but the expansion has continued faster in the current crisis, moreover without any prospect of the money supply contraction of 1929-32. Government budgets have been running consistently higher deficits than in 1929-32, on a world basis, especially in the advanced countries, but also in emerging countries.

At the latest count the overall global stimuli – fiscal and monetary, national and international – appear to have reached a previously unimaginable scale of the order of $15 trillion. We have grown indifferent to inconceivably large sums, and the arithmetic of government finance has fundamentally altered (“Is Trillion the New Billion?”, asked Robert Hahn and Peter Fassel, Economist Voice,, January 2009. Italian readers are easier to stun if they think of a trillion dollars as 1.4 million billions of old Italian liras). But most of those trillions are only on paper or are not yet getting spent. It is arguable whether the small improvements noted by Eichengreen and O’Rourke amount to “green shoots of recovery” (they deny it). Yet there have been premature calls for an exit strategy (for instance by the German Chancellor Angela Merkel and the ECB President Jean-Claude Trichet). Worse, a collective exit strategy was considered – though rejected for the time being – by the latest G-8. We should be so lucky to have a double dip, a W-shaped pattern of GNP instead of an L-shaped one or worse.

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