Duncan’s Economic Blog

What’s going on?

Posted in Uncategorized by duncanseconomicblog on March 11, 2009

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.

4 Responses

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  1. newmania said, on March 11, 2009 at 10:52 pm

    On the other hand deflation means salaries and savings are worth more and is generally rather liked . I cannot see the panic and I notice cheery faces at the Supermarket. You point about spending drying up is only speculation , why by a watch a computer a DVD and so on when it will be cheaper tomorrow ? Doesn’t work does it
    I find what you say about “Just in time “ manufacturing interesting and such thought has occurred to me in an inchoate way. I occurred to me when I thought if all the money wasted on bad banks had set a good one with the inter web we could be in it tomorrow , technology has changed out of all proportion in the last ten years . Additionally the values of business selling retail services seems to me to be about zero if it based on client base as has been suggested …well the building might be worth a bit everyone goes with the press of button. Saving banks looks like bad bad deal for the taxpayer to me , saving Northern Rock is mystifying ( well not given where it is ….)
    All of this leads me to suspect that throwing money at companies only viable in a debt based false boom is not a good idea and a shake out is part of the cure . The system is not purged of excess house prices are still at levels considered vertiginously high a year ago. Plenty of weak companies are still trading and plenty of borrowed money is still sloshing around in one form or another ( well is in my biz anyway)
    You always say Demand demand demand but aside from preventing galloping deflation( …..Public Sector workers just a got a pay rise , train fares just went up , fuel bills are still hideously high, when does it start ?). What good does it do ? You risk a long term inflationary problem which will stop any recovery in its tracks and if this demand is crated by printing money the adjustments that need to be made will not be made. I do not even get onto the National debt . It is more the flabby public sector and its clients that need to be “reformed” because this effects the real defacit
    Confidence is a rather different thing to demand . Confidence returns when people do not suspect that nothing is worth much really . This will only return when there are people worth lending to and we can see who they are .You wish to prevent this and it makes no sense to me

    The best plan is to fund as much in tax cuits as we can and fund it with real reform of the wasteful PS. AS this is financed with future tax rises on tax payer flinging it at Labour`s benefit vote will not be politically acceptable to those who actually make the beans

    Anyway having carped probably quiet ignorantly that was a great post and this looks like being an excellent site .

    • duncanseconomicblog said, on March 12, 2009 at 11:38 am

      Newmania,

      I think deflation can be good or bad. Deflation can be caused by technological progress (railway lowering transport costs in the nineteenth century) or by a fundamental chnage (China’s entry into the global entry, pushing down costs of manufactured goods). In these cases, then yes deflation is good – it lowers costs.

      However defkation can also be destructive, deflation caused by a fundamental lack of demand is likely to make demand even weaker. That coupled with high debt levels can be dangerous.

      I would argue that in the early noughties Central Banks mistook ‘good’ deflation (arising from China) for ‘bad’ deflation and cut rates too far. But I also argue that what we face now is ‘bad’ deflation.

  2. Nick Drew said, on March 12, 2009 at 12:07 pm

    There is a fourth danger to the optimistic view, as I hinted here in the first comment. A refined just-in-time supply chain is a delicate thing, almost by definition. When manufacturers eventually flick the on-switch, they may find that their carefully developed chain doesn’t spring back into action as readily as they’d hope.

    Some of this is to do with commercial structures, some to do with simple physical infrastructure. If a steel plant shuts down for 9-12 months, even if coal and iron-ore will be easy to source when they decide to get started again I’m willing to bet that the railway links will have fallen into a mild state of disrepair.

    Everything can be rebuilt eventually, but it doesn’t necessarily mean the patterns of the downturn and the upturn are symmetrical.

  3. charliemarks said, on March 13, 2009 at 2:05 am

    Arguably the best way to get credit flowing again is for the banks to be nationalised. I think this worked in Sweden quite well and here’s why:

    Commercial decisions will still be made on who to lend to and at what cost to the lender – but public ownership will get around the one big obstacle, which is that the people running banks are looking to provide returns to the owners and so make decisions on lending in a different way. Instead of being cautious about lending because they are mindful that their job is to give a return to investors, they will be more eager to lend, but nonetheless mindful of risks, etc. We can see the government has reversed its previous policy with Northern Rock.

    With public ownership it’s not about the sectional interest of shareholders (or even, the government as shareholder) but about the interest of the whole of our economy in the long term – ensuring that productive enterprises get the financing they need.

    The big problem with all of this will be the EU’s rules on these matters. Sweden’s banking crisis and it’s recovery happened prior to the country becoming a member of the European Union. The political right likes to paint the EU as some kind of warmed-up Soviet Union, but in fact EU institutions would probably oppose nationalisation of the private banking sector on several grounds (competition rules, the rights of shareholders, etc.).

    Now, it’s the kind of measure that might need EU approval, and might take a damaging length of time (look at the govt assistance to our car manufacturers – it was held up while the European Commission vetted it). But the government will have to be tough and say it will take the consequences from the Commission.

    As to the future ownership in the banking sector, I think we would be wise to learn the lessons of this crisis: the shareholder-as-owner has proven dangerous.

    Which financial institutions have been responsible and have not needed public money to bail them out? The building societies, owned by their customers: no one expects from building societies anything other than boring banking – no financial wizardry. Indeed, many of the failed institutions were once owned by their customers – Bradford and Bingley, Halifax, Northern Rock, etc.

    As a customer and member of a building society, I don’t ask much more than a good service, either as a lender or saver; I certainly don’t demand of the people running it that they come up with more ways of making money. Now it might be argued that this kind of high-street banking doesn’t apply to the financing of bigger businesses – but my question would be, why not?


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