The wonderful world of financial innovation and global imbalances started to go wrong in 2006. The unthinkable happened and US house prices started to fall. This was apparently so unthinkable that the ratings agencies (the guardian of financial probity that had given assets back by subprime loans their top ‘AAA’ stamp) had no variable in their models to cope with nationwide falling prices. By mid 2007 it had dawned on the market at large that this meant that any asset backed by subprime debt was likely worth something less than 100 cents in the dollar. In June 2007 two hedge funds backed by Bear Sterns suspended redemptions of client money. A small German bank, IKB, announced large losses and had to be bailed out by a consortium of other banks. French bank BNP Paribas announced its own losses. By August of 2007 the interbank lending market (in which banks lend to each other) had totally seized up, the interest rates charged had leapt and any bank dependent upon the capital markets to fund itself was facing a problem. By September Northern Rock had turned to the Bank of England for aid and a panicked public queued up to withdraw their money.
Banks around the world began a long, drawn out and continuing process of announcing large write downs of assets at each quarterly results. As credit dried up economic activity began to slow and so more loans risked turning bad. This only spread further mistrusts throughout the financial system, resulting in even less credit being available.
The financial catalyst for the current fall came in September 2008 when Lehman Brothers, one of the US’s larger investment banks, was allowed to go bankrupt. The perception that it was in trouble meant that no one would lend it the money it needed to stay operational. Its bankruptcy created a new wave of panic which culminated in the first round of government bailouts of the sector in October last year.
The damage however was done. The world economy suddenly went into what can only be described as free fall, with large falls in global trade. Industrial production and economic growth fell heavily across the globe in the 4th quarter of 2008 and seem set for each large falls in the current quarter too.
What on Earth happened? Whilst most observers had, by late last year, acknowledged that recession was likely, few foresaw the speed of the decline.
I suspect the unavailability of credit had a much larger impact than many expected. I also suspect that the growth of ‘just in time manufacturing’ over the past decade, coupled with the effects of new technology on managing global supply chains played a major role. In previous recessions it took time to stop production. Companies had large inventories of unsold goods that could be run down, indeed Keynes put a lot of emphasis on inventory adjustment as a way of understanding the business cycle. Last year however it was possible for companies around the world to simply shut production down quickly. This has led to very large falls in GDP across the world. In the fourth quarter of last year GDP fell by over 20% (on an annualised quarterly basis) in Korea (one of the first steps in the global supply chain), by over 10% in Brazil, Mexico and Japan and by over 5% in Europe and the US. These are major falls.
The possible silver lining is that a short, sharp, nasty recession might be better than a marginally lighter but much slower drawn out one. One could argue that the six months from September 2008 until March 2009 might simply be the system purging itself of excess, before it resets at this new lower level and starts to grow again.
I worry that this picture is two rosey. There are three dangers now. First, the financial system remains broken – despite billions of pounds of public money being poured into it. Until this system is fixed, money will not flow freely through the economy. Second global confidence has vanished. Faced with the prospect of a recession both households and companies are cutting back on discretionary spending – to this extent the recession becomes self reinforcing. Finally there is a real prospect of deflation, i.e. a sustained fall in year on year prices. With too much productive capacity and not enough spending, it is perfectly possible that companies will start cutting prices. Whilst deflation might sound beneficial, it is actually a curse. As goods continue to get cheaper consumers stop spending, why buy a TV today when it’ll be cheaper tomorrow?
If an indebted economy, such as our own, enters a period of deflation the results are even worse. As prices fall the real value of debt increases, so the consumer and corporate become more and more indebted. It was this ‘debt-deflation’, first described by Irving Fisher in the 1930’s (after he had managed to blow up the investment bank he was running) that made the Great Depression ‘Great’.
If demand continues to fall and deflation arrives, then a decade could be lost – as happened to Japan in the 1930’s. The financial system must be fixed, demand must be restored, confidence improved and deflation avoided all over the next few months. To complicate matters further, in the case of Britain, this must be done against a backdrop of the unwinding of global imbalances and re-footing of the economy away from financial services. These challenges will not be easy.
The economic history of Britain’s next decade will be decided in April. A sweeping statement perhaps, but a fair one; the budget and the G20 summit represent the best, and possibly last, chance to prevent a nasty recession in the UK becoming an all out depression. So, in an egotistical manner, I thought I’d set out my own thoughts on the situation we are facing and steps that should be taken.
Tempted as I am to launch straight into my own policy prescriptions, I think that would be foolhardy. It is important first to set out how we came to be in this mess and to understand exactly what we mean by ‘credit crunch’. So I thought that, on my inaugural day of blogging, I would open with two posts. This (rather long) one setting out how we came to be here and a second on the nature of the problem as it currently stands. Over the next few days, I’ll start laying out some ideas on what we can actually do about all this.
To my mind the current situation has two causes – global imbalances and financial innovation. Both are equally important and both, to an extent, fed off one another.
The Asian Crisis of 1997/98 was a classic emerging markets crisis of the type often witnessed in Latin America. Simply put the ‘Tiger’ economies of Asia attracted too much foreign investment and grew too quickly, half of all foreign direct investment into emerging markets flowed to Asia in the 1990s. In addition too much debt was taken on by consumers, governments and corporates – often borrowed in US dollars rather than local currencies. Starting with the fall of the Thai Baht, a chain reaction began that saw currencies, stock markets, property prices and asset prices generally collapse across the region. The fall in local currencies against the dollar exasperated the problem by making the local currency value of dollar denominated debt higher.
After the crisis a mentality of ‘never again’, was understandably adopted across the region. The experience of 1997/98, coupled with the lack of an adequate social security net, led to Asian economies saving too much. In addition the governments, stunned by the rapid falls in their currencies, started to amass large portfolios of foreign currencies to defend their currencies in the future. China, the world’s biggest reserve manager, now has over 1.2 trillion dollars of reserves. Malaysia, Taiwan and Thailand all have more than the UK.
Of course this savings have to go somewhere, and much of them flowed to the West. In effect the West spent more than earned for a decade, whilst Asia earned more than it spent. This was the ‘global savings glut’ as termed by Fed Governor Bernanke in 2005.
In other words, the world economy suffered from a great imbalance of spending and saving. The process of this transfer was quite straight forward. A Chinese worker would save about 40% of his or her earnings by depositing them with a state bank. The State bank would ‘lend’ those deposits to the People’s Bank of China (PBOC). The PBOC would then buy Western bonds using the money. Ultimately the inflow of money from Asia allowed the West to spend more than it earned. Of course much of that spending went on buying goods from Asia. In effect we have been running up a bill since 1997.
One good way to measure this phenomena, although imprecise, is to examine the loan-to-deposit ratios (LDRs) of Western banks. Most people probably assume that this level is around 100% – i.e. for every pound of deposits a bank has, it will make a loan of £1. For most Western banks this ratio is well over 100%, i.e. they lend more money out in loans than they take in in deposits. The so-called ‘customer funding gap’ (the difference between deposits and loans) in the UK is currently around £700bn. In 2001 it was basically zero. Over this same period, the UK household savings rate (the percentage of money saved by the average household after tax) has moved from about 6% to under 1%. In the US, the savings rate actually went below zero.
So global imbalances offer an explanation to the often asked question, where did all this money come from? The West enjoyed a decade long boom, fuelled by cheap borrowing from abroad which lifted house prices, boosted consumer spending through easily available debt and hence corporate profits.
Coupled with this imbalance, we saw unprecedented financial innovation. Once upon a time banking was a simple business, summed by the old bank managers’ adage of the 3-6-3 rule: pay 3% on deposits, charge 6% on loans and be on the golf course by 3pm. This happy situation changed with the growth of securitisation. Rather than simply make a loan and hold it on the bank’s books for its life, collecting interest along the way bankers came up with a new model. Make a bunch of loans, then take them off the books, package them together into an ‘asset backed security’ and sell them on to someone else. In this way banks could keep making loans regardless of their levels of deposits. This so-called ‘originate and distribute’ model was heralded as making the system less risky. Not only did it allow continued credit expansion but, it was claimed, it would reduce risk exposures by spreading the risk of default around the system, rather than concentrating it on banks’ balance sheets. This is a nice theory. It is also utter rubbish.
The greatest excess of all was subprime lending – banks lent money to those you couldn’t really afford to pay it back and then sold on the loans. If the loans went bad, the theory ran, it wouldn’t matter – the holders of the debt could simply seize back the house and sell it on to recover their potential losses. It is worth mentioning that ‘subprime’ is not entirely an American trait – the UK buy to let market has many similarities.
So what went wrong? House prices began to fall in the US, meaning the ‘security’ underwriting subprime loans was removed. Now defaults suddenly mattered as a loss would still be realised even if the house was seized and sold on. And as the risk was now spread through the system, no one really knew where it lay. So lending between banks seized up – no one wanted to be caught with exposure to an institution that might unexpectedly blow up the next day.
Ten years of global imbalance had created economies in the West that were addicted to debt.
Want to buy a house? No need for a deposit, we’ll give you a 100% mortgage. Need some furniture too? No problem we’ll make it 120%. Or just pop down to DFS and buy a sofa on credit. Want a car? Fine, get an auto loan. Planning a holiday? Why save up when you can put it on a credit card? You’re running a business and you have to pay your suppliers today but won’t receive money from your customers for 30 days? Not a problem at all, get an overdraft. You want to build a new factory? Fine, issue some bonds.
The sudden seizing up of credit, which had seeped into every corner of the economy, had major consequences.