Why Now?
on March 18th, 2008 at 3:13 pm
Why Now?
There has been no shortage of commentators and players willing to vouch that this is the worst financial crisis they have ever seen. Equally, there has been no shortage of bailout moves by the Federal Reserve–remedies that put “the Greenspan Put” to shame in their magnitude.
And yet the market meltdown continues, and the casualties continue to mount, with Bear Stearns the latest–and surely not the last.
In all this, no one yet seems to have posed the question of “why now?”. Why is the crisis clearly more severe this time than ever before, and why are remedies that worked relatively quickly in the past (remember the fast turnaround of the market after October 1987, and the rapid recovery from the rescue of Long Term Capital Management?) failling today?
The answer is, simply, that the world has never in its history carried the level of debt that it is carrying today. The remedies that worked when America’s private debt to GDP ratio was a mere 150 percent (see Figure 1) are inadequate when that ratio is 275 percent.
Figure 1: Debt to GDP Ratios over the Long Term
Those remedies worked in the past, not because they “solved the problem”, but because they encouraged the renewal of the debt accumulation process. Each Federal Reserve rescue was followed by a renewed growth of debt relative to income–without which, the economy would have gone into a slump, rather than a boom.
The traditional cure to a financial crisis–to restart the debt accumulation engine–can’t work this time, because in America today, there’s no-one left to lend to (there is no sub-subprime borrower), and no lender willing to risk its capital in yet more debt.
So the dominoes will continue to fall. Manoeuvres like extending the range of securities that are eligible for the Federal Reserve’s repo window will provide temporary liquidity. But while that liquidity exists, the financiers then have to find someone else willing to give them the medium term credit needed to honour the other side of the repo agreement–to buy the securities back from the Fed when the repo agreement expires.
That could be when the next dose of the proverbial manure hits the proverbial fan. The repo agreements that the Fed will arrange will doubtless involve discounts to face value of the bonds being accepted as securities. The firms that take out that temporary liquidity then have to buy those bonds back–and without reserves to draw upon, that will involve further debt.
What odds that it won’t be possible to find that debt, unless the bonds can be repossessed at a higher still discount? What will the Fed do then? Bankrupt the primary dealers who can’t honour the second leg of their repo agreements? Validate the folly of sub-primes by permanently buying the toxic securities they have accepted as collateral–and at what discount? And, with what money, since the reserves of the Federal Reserve are dwarfed by the scale of outstanding private debt?
So the real fun on the markets will begin in three months time, when the credit extended by the expansion of the liquidity window yesterday by the Federal Reserve has to be repaid.
“Fight Inflation First? Not on your Nellie…
One more recent piece of news out of the USA deserves comment: the fact that inflation for the month of February was zero. This might be a flash in the pan: certainly there are plenty of sources of inflation in the world economy now, amplified in the USA by its depreciating currency.
From one point of view, it is good news, because it means the Fed doesn’t have to excuse itself from kowtowing to the market’s standard paranoia about inflation.
But in another sense, it could be a harbinger of deflation–and this is the last thing the USA–or the world in general–needs. That is emphasised by taking another look at the USA debt data in Figure 1–this time in conjunction with data on inflation and real GDP change–in Figure 2 below.
Notice that the USA’s debt to GDP ratio peaked at 215% in 1932–three years after the Great Depression began–having been “just” 150 percent when the Great Crash occurred.
The reason that the ratio continued to grow after the Depression struck is twofold: firstly, real output fell–and by as much as 13% in 1932; but secondly, because prices fell by over 10% p.a. in 1930-32. That falling price level increased the debt burden, even as Americans tried to pay their debt down.
For the record, the USA revisited the peak for the non-financial debt to GDP ratio in 2005–and the ratio including the financial sector debt exploded past even the Great Depression’s peak in 2000. It is now 278 percent, versus 150 percent in 1929, and 215 percent in 1932.
Figure 2: Debt and Deflation
Hyperproductive,
the reason I suspect we continue to make mal-investments is that normal rules of supply and demand (and resulting price) wrt loans and interest rates do not exist while the central banks fiddle with short term interest rates.
If a normal market was to apply to funds people wanted to borrow, then if demand for loans exceeded supply, you would pay a higher interest rate, and subsequently would ask questions of the investment requiring the borrowing (do I really want this, does it make a good enough return to fund the loan etc.)
As it currently stands, more demand for loans has very little impact on the price of those loans.
I believe that this disconnect between the demand and price of loans is a major reason for malinvestment.
One consequence of allowing floating interest rates would be that the link between cost of loans and demand would be re-established. Could be very torrid though to get there.
Hi Steve. Sorry for posting off-topic, but there is an increasing amount of chatter around lately concerning the EFM product you were so critical of when it was announced a year ago. I’ve looked around your site here (and my hard-drive) but can’t find your original analysis of the product with the charts and so-on. I was hoping perhaps you could put a copy up on this site somewhere if it isn’t here already? Thanks, F.
Hi Foundation,
I took it off under threatened legal action from the promoter, but the threatened legal challenge never arrived, so I’ll pop the analysis back on my Debtwatch reports page.
Hello Steve
This is my first two-bobs worth to you and your great forum. My apologies if I’m only repeating what may have already been covered here, but I haven’t had the liberty of reading all of the issues.
Having an economics background, I’ve been greatly concerned for the last decade that we’ve managed to make investment in productive assets much less attractive than speculating in non-productive “assets”.
We have negative gearing that encourages money to be pumped into housing, but we continuously dream up more & more ways to stifle productive investment. Red tape and regulation (eg. BAS, OH&S) strangle investment in production and then we tax the crap out of any profit that has been made.
My view for a long time has been that negative gearing and depreciation benefits should be scrapped for housing unless it is for new building. If you are not the first owner of a house, you don’t get the incentives. Extending these incentives to owner-occupiers as well investors for new dwellings would then encourage investment in expanding the stock of housing if need be, rather than inflating the prices of existing stock.
Is this too simplistic as a start?
Cheers