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December 17, 2007
The global crisis in financial markets arising from the sub-prime mortgage crisis in the US continues to unfold in good dialectical fashion. Last week we had an emergency action plan-- a bail out?-- by the US Federal Reserve and four other central banks (Banks of England and Canada, the European Central Bank and the Swiss National Bank) that injected lots of liquidity ($70 billion) into global financial markets.
Is it a case of too little too late? Is the current turmoil in the US just a liquidity crisis? A “temporary” credit crunch, as it were? Or is it something more?
Steve Bell
This bailout, it was argued, would help banks to continue borrow to fund their activities. The Central Bankers big fear is that the US housing problems will drag its economy into recession and damage worldwide economic growth. There is now a serious risk of a global economic downturn in 2008 as the US inevitably heads towards a recession, and this recession leads to economic recoupling across the globe.
The signs are not good: banks in America are warning that their write downs will be greater than predicted; Britain's house price bubble looks to burst because of the credit crunch; the interbank system is not working very well; the regulatory systems in Asian countries are vulnerable to the forces flowing through global markets; the U.S. current account is in bad shape; inflation is becoming more of a threat in Australia, Europe and Asia. Moreover, the US dollar continues to weaken and, as it is the major currency for trade, its continuous depreciation will push up prices of oil and gold and reduce the wealth of dollar-holding nations (eg. China, America's creditor). Or is this a case of a dirty float?
That's a dollar crisis on top of a credit crunch, poor governance and a weakening economy. That's a lot of friction and anxiety being generated within the political economy of the world of nations, and the rippling effects can be felt everywhere.
What if the events unfolding in the US represent a debt or a insolvency crisis among a variety of borrowers that over-borrowed excessively during the boom phase of the latest credit bubble? What if the end process of the economic flows are insolvent and bankrupt households, mortgage lenders, home builders, leveraged hedge funds and asset managers? What if we have a liquidity crisis that signals a more fundamental debt, credit and insolvency crisis among many economic agents in the US and global economy?
If so does that not require more than liquid injections to deal with the causes of the credit crunch? Paul Krugman says:
In past financial crises — the stock market crash of 1987, the aftermath of Russia’s default in 1998 — the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn’t working. Why not? Because the problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.
This is a world of bad debts and falling equity. As Krugman observes there’s a lot of bad debt out there in the US and you just don’t know how much of that bad debt is held by the guy who wants to borrow your money.That's a serious case of lack of transparency and thus a regulatory issue.
The global bailout addresses the issue of the interbank system not working very well (the banks don't trust one another), but not the other issues. Nor will the monetary easing through interest rate cuts by the Federal Reserve in the US prevent the unavoidable hard landing in that nation's economy. At best it will only postpone the necessary restructuring after a reckless credit-boom driven asset bubble. Liquidity injections by themselves do not resolve the deep insolvency problems of many overstretched borrowers--households, financial institutions, corporates-- in the US.
A possible scenario is that a US hard landing followed by a global slowdown will seriously reduce the current inflationary forces, as these will lessen once the US hard landing is in full swing. If so, then we need to ask: why do central banks allow credit bubbles to grow and burst? Why don't the central banks work to bring about regulatory reform of the global financial markets? Why aren't there moves to bring non-bank financial institutions into the regulatory framework? Why is there a lack of movement to create a sounder and more transparent global financial system?
Update
The rippling effects of the credit crunch continue to bite in Australia. RAMS Home Loans was unable to refinance some of its loans. Now the Centro Group, a management and property group of companies, has revealed that it has been unable to negotiate a package to refinance $1.3 billion and unable to roll over $3.9 billion in short term loans that expire on February 15, 2008. There’s an additional $3.4 billion that falls due within 12 months and the remaining $10.6 billion expires some time after that. Shares in Centro Properties Group collapsed today.
The banks have become more risk averse and various bankers have basically pulled back from lending to property assets. This has led to hefty increases in the cost of capital for other borrowers. Centro, which manages $26.6 billion in property and specializes in the ownership, management and development of shopping centres, had borrowed heavily to finance a rapid expansion in the US where it had acquired relatively low value assets. Consequently, a debt-laden Centro,was faced with higher borrowing costs and the need to make major asset sales to reduce its debt. It is now tottering on the point of collapse, with its fate in the hands of its bankers.
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