What’s going on?
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.