An increasing number of commentators and economists, led by Nouriel Roubini, have been saying that the sub-prime mortgage crisis is more a solvency problem than a liquidity crisis. This is borne out by the fact despite the hundred of billions of dollars and euros liquidity injections and a 100 basis points cut by the Fed in the US, over the last three months when the bubble strated signs of having the potential of dragging the economy with it, the bad news continues to tumble in. Simple monetary and other supply side interventions will not solve the more fundamental credit quality related problems. But neither does it dispense with the need for monetary easing.
Nouriel Roubini tracks the extent of damage inflicted till now, "Indeed, you have two million plus US households that will likely default on their mortgages; dozens of mortgage lenders who have already gone bankrupt; plenty of homebuilders suffering losses and closing shop; highly leveraged financial institutions all over the world (US, UK, France, Germany, Australia, etc.) that made reckless investment and have gone belly up; and even corporate firms defaults will now start to sharply increase as the economy falls into a recession. Also, the size of the financial losses are staggering and growing by the day: financial institutions have so far recognized about $50 billion of losses but a variety of analysts estimate that total losses in sub-prime alone could add up to $300 to $400 billion; add to those the losses in near prime and prime mortgages; the losses on credit cards and auto loans whose default rates are rising; the losses on commercial real estate that experienced a boom and bubble similar to residential real estate; the losses that will be suffered by banks on lending to corporate firms and in LBO deals. It will all add up to a staggering figure closer to $1,000 billion of losses."
Roubini calls it the first crisis of financial globalization and securitizations, "Given such losses, the necessary contraction of credit by financial institutions that have lower capital could reduce the stock of credit – and thus cause a massive credit crunch – of the order of several trillions US dollars. In turn, such credit crunch will make the quantity of credit lower and its cost higher for households, firms and borrowers in general, thus reducing aggregate demand. Moreover, given securitization and financial globalization these losses are spread not just among banks but also investment banks, hedge funds, mutual funds, money market funds, SIV and conduits, insurance companies in the US and across the world. Thus the financial contagion is spreading from banks to the rest of the financial system and from the US, Europe and the rest of the world increasing the risk of a systemic financial crisis."
"Thus, no wonder that major financial markets are now in a seizure of credit and liquidity: interbank markets, SIVs financed by ABCP, securitization markets, derivatives markets, LBO markets, leveraged loans and CLO markets. Given uncertainty on the size of the losses and on who is holding the toxic waste assets everyone is afraid of their counterparty and is hoarding liquidity. This is the effect of having created a financial system with less transparency, more opacity and lack of information and financial disclosure."
Roubini also says that the individual consumer will not be spared, "The saving-less and debt burdened US consumer is now at a tipping point. It cannot use any more its home as an ATM machine by borrowing against it and spending more than its income as home wealth is now falling. This consumer is buffeted by many negative shocks: falling home values, falling home equity withdrawal, rising debt servicing ratios, a credit crunch in housing and consumer credit, rising oil and gasoline prices, a weakened labor markets and, soon enough, a falling stock market."
Any liquidity crisis at this time of the year will have more long term effect and on the real economy. Private consumption spending forms 70% of the US GDP. The coming Christmas and New Year period are the peak sales periods, (forming upto half the annual sales of many products) and the rapidly disappearing "income effect" (coupled with a fast increasing "debt effect"!) is likely to seriously dent consumption spending. The free spending US consumer had been using the booming home prices and the tech stocks before, like an ATM to borrow against. At a time, when private sector investment spending in Europe and especially US is stagnant and even falling, a poor year-end sales season will surely postpone future investment decisions. The inflationary expectations fuelled by rising oil and commodity prices and weakening dollar, will only strengthen recessionary trends.
And the consequence of all this on the vital credit markets that drive the global economic growth, especially with private sector investment spending stagnating since 2004 and a recession looming, could be catastrophic. In fact it could be the decisive factor in determining the extent of any future recession.
Roubini accepts that recession is inevitable in the US and Europe, even with any monetary easing. But despite the limitations of monetary policy, Roubini argues that in its absence the inevitable recession is likely to be steep and long, and have far reaching consequences. He feels that while monetary easing will not prevent a US recession that is now necessary to clean up the credit mess, leverage and excesses that were built up in the last six years such monetary easing may reduce the length of such a recession and dampen its depth. He argues, "When bubbles go bust the Fed can only minimize the collateral damage to the economy and reduce modestly the severity of the losses; it cannot prevent massive losses and sharp falls in asset prices from occurring as the experience with the S&L boom and bust in the late 1980s and the tech boom and bust in the late 1990s suggests."
Calling for bigger and more definitive cuts in interest rates, he argues, "When your home is on fire and there is serious risk of fire contagion to all of your town and beyond you want the entire fire brigade to provide enough liquidity to avoid entire edifice and town burning to the ground. And using hand-held and hand-carried buckets of water while pondering the intellectual merits of moral hazard of fire insurance in order deal with a major five-alarm fire - rather than using immediately your global fire brigade - is delusional. So it is time for the international central banks’ liquidity fire brigades to turn on the hoses and dealing with this most dangerous global fire."
He writes, "So the time for band aid measures and clever but ineffective palliatives is over: only a monetary policy ease could make some difference in reducing the level of interbank rates (if not the interbank spreads) and avoid the sharp tightening in monetary conditions and rise in real short term interest rates that the spike in interbank spreads has created."
About the need to bail out the real economy and prevent milliions of job losses, he writes, "And it does not make sense to avoid bailing out the real economy – and preventing a massive global loss of incomes and jobs – just in order to punish reckless lenders and investors in the financial market and thus avoid moral hazard. Moral hazard in financial markets is contained via sensible credit policy and appropriate regulation and supervision of financial markets. In times of economic danger bailing out the real economy with monetary easing may have the by-product of partially reducing the financial losses of reckless lenders and investors (an indirect bailout). But the first order costs of a global recession is much larger than the second order costs of partial moral hazard; such moral hazard will be kept in check by hundreds of billions of dollars of losses that will occur regardless of monetary policy easing and via sounder regulation and supervision of financial markets in the future up-cycle of credit."
He also feels that the fears of inflation are misplaced and on the contrary, predicts global disinflation in the aftermath of the recession, for the following reasons.
a) a fall in US aggregate demand relative to supply;
b) a slack in labor market conditions and slowdown in wage growth as the unemployment rates sharply increases;
c) a fall in global aggregate demand as the glut of output from overinvestment in China and some other EMs will face a fall in global demand as the world recouples with the US hard landing;
d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges. We are set for the repeat of the 2000-2003 cycle when the Fed and other central banks underestimated the downside risks to growth and overestimated the upward risks to inflation and ended up having to aggressively cut rates to deal with the fall in economic activity and the deflation risks that such a US and global recession triggered.
Roubini also lists out the likely objections to any monetary easing now, and argues against the primary objections. The major concerns are primarily the following
a) such monetary easing will not prevent a hard landing and will only postpone the necessary restructuring after a reckless credit-boom driven asset bubble;
b) it will cause moral hazard and possibly create future bubbles;
c) it may lead to higher inflation.
It is true that these remain the major immediate concerns of a monetary easing. But the case made out against each is less than convincing. The comparison with the tech bubble bust is wholly inappropriate given that unlike the mortgage crisis, the tech bubble affected only a small portion of both the real economy and the financial markets. The reasons given against inflation are assumptions, all o which are in turn based on further assumptions which stand on shaky foundations. Roubini and most serious commentators agree that a hard landing is inevitable and even desirable. Given this scenario, and also given the potential for huge losses, any monetary easing will introduce severe distortions in the market. The Government is itself likely to be sucked into misguided bailout efforts dressed up as efforts to prevent the contagion from spreading to the real economy. This is time enough for the development of a few more toxic financial products and their being offloaded into unsuspecting investors. One does not need to look far into history to know that such delaying the inevitable has only helped generate numerous other unpredictable distortions.
Here is a classic case of an economy which suffers from serious macroeconomic imbalances The low inflation, low interest rate, credit and asset booms of the last two decades has spawned in its wake massive current account deficits and a negative household savings. These imbalances had been building up for a very long time. But for small blips, this has been one long unsustainable boom. The single critical parameter driving the imbalances has been credit, and any effort to pump in more of the same will, in all probability, only distort the market. Monetary easing to address any recession now, is a little like fighting fire by pouring more fuel!
Update
Greg Mankiw has his views on what to do during teh coming recession, in his NYT column, How to Avoid Recession? Let the Fed Work. He feels no need for any Government intervention and feels that the Fed should be given the freedom to act as the situation warrants.
No comments:
Post a Comment