Deliver Us from Davos

by Dollars and Sense

The Dull Compulsion of the Economic: the 12th in a series of blog postings by D&S collective member Larry Peterson

After a week of financial turmoil unlike any seen since September 11th, 2001, or, arguably, even before that, it behooves us here at D&S to take a stab at figuring out where the hell we are. First and foremost: regardless of whether or not we’re technically in recession or not, a whole lot of folks are going to get hurt from this, and over a longer period of time than previously thought; and though it’s kind of cool, as many commentators have noted, to watch the spectacle of formerly turbo-charged advocates of “unfettered” free markets go, begging bowl in hand, to the reviled state, or even to those paragons of state and even crony capitalism, Sovereign Wealth Funds, we must consider it our primary objective to show solidarity with those who will lose jobs, get foreclosed on, or endure other, countless sufferings thanks, in no small part, to the greed and arrogance of the corporate welfare queens (though, it must be said, many ordinary people, dreaming of the joys of being landlords, or simply of finally getting their own homes in spite of lagging wages, allowed themselves to be carried away by the hype spewed by downright crooks, and even plain-vanilla bankers, as yesterday's New York Times suggests may have been the case).

That said, let’s move on to an analysis of the current conjuncture. After important bond insurers’ top ratings were threatened (due, ultimately—and at a the end of a very long chain of causation—to subprime exposure) on January 18th, Asian and European markets suffered humungous losses; the fear that the ratings downgrades would result in falling prices on a cascading range of bonds, coupled with unrelenting indications that the US economy was already in recession (and, as we shall discuss in a minute, that Asian exporters were showing greater slowdowns—and hence dependency on exports to the US—than previously thought), was responsible for much of the selloff. But if this weren’t enough, a rogue trader at the French fincorp Societe Generale seems to engaged in a bit of fraud the likes of which hasn’t been seen since Nick Leeson brought down Barings Bank in the mid ‘nineties (though, the Financial Times reports that the trader, Jerome Kerviel, may not have lost the lion’s share of the 4.9 billion euros, and that the “board of SocGen lost the other 3.4 billion euros” by allowing the bogus positions to accumulate), and SocGen had to sell accordingly vast amounts of securities into falling markets to attempt to make up for the losses. This no doubt has symbolically confirmed that we have moved into a potential insolvency crisis, and that the bankruptcy of major financial institutions (which would challenge the ability of even hyper-accommodative central banks and deep-pocketed Sovereign Wealth Funds to fork out bailouts) is not as outlandish a thought after all: this is no longer simply a case of banks being unwilling to lend, or to take out loans themselves (or a liquidity crisis). This little aside was only beginning to play out this weekend, but the Federal Reserve decided to act even before this morsel was discovered in the toxic stew. With Monday being a market holiday in the US (in a strange twist of fate, Dr. Martin Luther King, whose memory was commemorated on January 21st, gave the Fed a little extra room to act), the Federal Reserve cut interest rates an astonishing .75% (a .25% bigger cut than that put in place after the terrorist attacks of September 11th), despite the fact that it was due to meet a mere week later (and financial markets have discounted another cut of at least .5% at the meeting). Markets seesawed—with huge swings, including a breathtaking one-day 600 point reversal on the Dow) all week, even as the Bush administration and Congress agreed on the outlines of a stimulus package. No one is convinced that the situation is under control.

So where does it go from here? Well, there seem to be two conceivable (at least to the people in charge) ways out of the mess. One concerns the financial sector, and the other, foreign consumer markets. Regarding the former, it all comes down to getting the lending transmission mechanism unclogged. By injecting monstrous amounts of money into the banking system, the Fed is hoping that so much money will become available to the banks that they will no longer fear or even care about subprime losses that will surface for years to come. This strategy actually worked in the early 'nineties, when the Fed engineered a "yield pole," in which short term rates (which the monetary authorities control) were driven down as far as possible in response to the (much smaller) S&L crisis. In those days, such activity on the short end almost invariably increased inflationary expectations, and hence yields, on the long end; and banks, which make their money (or at least largely did so this way in those Glass-Steagall, pre-securitization days) by borrowing short and lending long, were able to recapitalize their balance sheets quickly, even as the rest of us suffered through the first of what have become normal, jobless recoveries. But today, the situation is vastly different: long rates (corresponding to expectations of future growth) are languishing, and even panicky Fed cuts in short rates are finding it difficult to keep up with the long end in the dash to zero. Meanwhile, of all things, inflation is rising at rates unseen for years. Add to this the fact that the Fed seems to have lost the game of chicken it was playing with global investors, who now seem able to force it into cutting rates to in the increasingly vain hopes of preventing a recession (thereby avoid the associated losses in sales and profits) in the same way as speculators in China force the People’s Bank to raise rates in anticipation of yet higher rates to come (i.e. if they invest more, the threat of inflation will cause the PboC to raise rates, etc.). And the monetary strategy seems to be reaching the point corresponding to that Keynes characterized as “pushing on a string:” lending money that is almost certain to end up losing value, and so is not borrowed. Hell: in annualized terms, real interest rates are negative (I know,
interest rates have to be close to zero before we can start talking
properly about negative real rates...): 4.1% inflation (CPI: and
wholesalers seems to have had an even worse time of it) for 2007, vs. a
Fed Funds rate of 3.5% now, with another big drop almost certain next
week. Finally, a lot of potential lenders are scared of predatory-lending litigation, and borrowers seem reluctant to take out home equity as long as home prices seem destined to fall for a good while longer. So, on both the supply and demand side, serious impediments exist in the way of unclogging. And though key LIBOR interest rates have come down from their previous lofty position above the Fed Funds rate, "Libor, which is used to set many U.S. mortgage rates, continued to trade substantially higher than fed funds futures or the overnight indexed-swap rate, another gauge of short-term rate expectations. 'The Libor is a bit of a puzzle,' said Alistair Milne, senior lecturer in banking and finance at Cass Business School in London. 'The banks are stepping back and want to be a lot more careful. The Libor is a symptom of that, as they (lenders) are not as generous as in the past. What we are really seeing is the end of a 15-year-long boom in credit growth, especially on retail and commercial property.'" This from Pensions and Investments from January 26, 2008.

Some have argued that it is misleading to focus on such things, given a globally financialized economy: rate differentials within nations, even the US, aren’t as important as those that exist between economies. That being the case, imbalances can be ironed out as finance follows the flow of trade (the US should import less, and solve its current-account deficit, whilst increased demand in Asia and even Europe allows for trade growth in the meantime). But, as the International Herald Tribune (amongst others) pointed out this week, Asian exporters have been far harder hit by the slowdown in the US than previously believed, and this has caused some economies (especially Japan’s) in the region to contract rapidly. Regional stockmarket performance reflects this: Japan’s NIKKEI has lost some 15% of its value in the last few months, and China’s Shanghai index lost 8% this week, in the largest drop there since the Asian crisis of 1998. And in Europe, both in the Euro zone and the UK, currencies are appreciating so fast that growth is certain to slow (both the Eurozone and UK are far more “open” economies, as measured by trade/GDP than the US, and more prone to slowdown as a result of currency appreciation). And this is assuming no further fallout from the subprime/securitization crisis.

The global elite have been meeting in Davos all week, and there have been calls from the likes of Bill Gates for a new kind of capitalism, one which uses the state to direct demand toward initiatives towards the poor (and hitherto nonproductive) parts of the world that will increase "human capital"—God, I hate that phrase—and so end up paying for themselves via increased productivity and, eventaually, increased demand. I've heard talk like this before: about ten years ago, Rosabeth Moss Kanter of Harvard Business School wrote a nauseating piece in The Economist (at least she picked the right place for it) in which she called for the state to step aside and let the internet elite run global development initiatives. One writer to the editor, in turn, noting the defects of Microsoft's products, monopoly rent extraction and cutthroat tactics, opined that we should, instead, let them "fix hell when they get there." I have a feeling that the world economy may be turning into the very hell these worthies would defend us from. Pray for an increasingly unimaginable economic recovery, comrades…or a revolution.

Labels: Davos, securitization, Sovereign Wealth Funds, subprime crisis, The Fed, World Economic Forum

 

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1/28/2008 11:12:00 AM