Eight Reasons to Prepare for a 2010 Credit Crunch

Debate over the present downturn mostly looks at cyclical issues and the best way through. Except this time really is different. Underlying structural forces are unresolved and current actions could make matters worse.

Eight structural factors give eight reasons to prepare for a crunch (with the last suggesting 2010):

First: We are off the map. The US Federal Reserve and Treasury, like their counterparts around the world, face unprecedented challenges:

1. Ensure adequate supply of finances, by countering banks’ de-leveraging through monetary policy;
2. Maintain demand, by countering reduction in consumption through fiscal policy;
3. Rebuild confidence by absorbing some of the debt problems emerging; and
   
4. Coordinate with other nations, as there are strong inter-dependencies.

The unique nature of one strand can be illustrated by the growth in the monetary base recorded by the Federal Reserve. From 1918 to 2008, the curve proceeds on a predictable upward path, with the odd bump, until going ballistic in late 2008. That doesn’t mean hyper inflation – the effect is produced by the Fed countering de-leveraging by banks. But it shows the biggest challenge for the Fed in its existence. To quote Mervyn King, Governor of the Bank of England: “Not since the beginning of the First World War has our banking system been so close to collapse.”

Although sophisticated techniques for economic management are being used, there is no indication that financial leaders have found maps to guide them. Paulson blames a global savings glut – too much money – whilst Bernanke will keep printing more until the economy comes right and Greenspan faults bankers’ behaviour (if only Wall Street was far sighted, well informed and well behaved).

Second: The compass is gone. The focus of monetary policy around the world has been keeping inflation (as measured by CPI) under control and, subject to that, encouraging economic activity through low interest rates (a Greenspan specialty). Low inflation – high growth nirvana beckoned. But, this policy assumes that: (i) the market – guided by light-handed regulation – would look after the rest, notably risk; and (ii) prices not covered by CPI – notably asset price inflation – didn’t matter much for the purposes of monetary management.

Well, wrong on both counts.

We’ll return to asset prices. Debate continues over why the market proved so poor at assessing risk. Aside from greed, I suggest two factors: First, the political push on extending cheap loans to doubtful businesses and households (think Fannie Mae (FNM) and Freddie Mac (FRE)). Second, the pricing problem: Prices are not arrived at by magic. In technical markets there are few price makers and competition revolves around their markers. To question their risk modelling for an asset class would be to renounce that market.

Sadly, the political involvement and damage to financial sector capabilities produced by the burst bubble will probably undermine risk assessment in the future too.

Whither monetary policy now that the focus on CPI has failed? Beyond the immediate crisis, there is no clear direction for central banks to follow. This makes life unpredictable - just what markets don’t like.

Third: The transmission and steering are shot. In terms of transmission: the stimulus of competition and the market is being weakened by the growing role of government. Two examples: (i) Auto executives will focus on Washington DC as their customer, not auto buyers. (ii) As banks remain highly risk averse, governments will become increasingly engaged as they seek results from the public money they have injected. Politically driven lending will result.

The net result will be more lobbying, more rescue packages, and more loan defaults, producing weaker economic performance.

Steering economic policy is awkward in the U.S. Unlike other central banks, the Federal Reserve is not part of government (though subject to limited oversight). But, it is making trillion dollar decisions and is central to navigating the turmoil. At international level, the elaborate Basle II accord to regulate banking has proved ineffective because it does not catch securitisation.

Fourth: The engine room has throttled back. The engine for global growth to a surprising extent has been the US consumer. This stems not from real wage growth but from the availability of cheap credit and the wealth effects of asset price inflation. Recent growth in household borrowing has exceeded 12% per annum – which is unsustainable. Consumption will stay shut down because of reduction in both the supply of credit (factor five) and the demand for credit.

Since World War Two, U.S. households have consistently grown their wealth by 3% annum in the medium to long term. In the last twenty years, this has been achieved through capital gains not savings – boosting consumption and encouraging borrowing.

The 2008 shock is so big that it cannot be shrugged off by households, like the 2001 downturn. With their wealth depleted, households will save: as a precaution in hard times, to make up for losses and try to regain their desired wealth path. Higher savings means lower consumption. A return to previous savings rates would result in a $1 trillion per annum decline in U.S. GDP. Cancelling out excess debt and asset losses would lead to a one off hit of several trillion more.

Fifth: The fuel supply is low. During the bubble, the intersection of Fed policy and U.S. household preferences led to cheap, easy credit and inflated asset prices.

Household debt (mostly mortgages) has surged 50% since 2001, leaving GDP and wage growth far behind. Borrowing is fine if used wisely, but in the U.S. it has largely gone into imported consumption goods (often from China – helping keep prices low) and driving up asset prices and housing stock (again with little impact on CPI). As official CPI didn’t rise strongly, the Fed saw no need to constrain the money supply and kept interest rates low to assist demand. Then the bubble burst.

Higher household savings may in future provide a greater source of lending for government or banks. But balance sheets in households and industry will take years to rebuild, and banks will remain more cautious over their exposures. Compared to the boom years, reduced banking leverage and lower asset values will cut available credit. Hence, the government and Fed face the challenges listed earlier. But:

Sixth: The tugboat can’t do it. There are three big problems.

First, government is limited in terms of fiscal policy. In the U.S. it accounts for 20% of GDP. Government cannot and should not replicate either the size or pattern of other sectors’ economic activity during the bubble. But, the harsh transition to a post bubble world will put pressure on government to do just that by trying to fill the big gaps that emerge: provide more lending, boost asset prices, bail out debt, purchase more autos and so forth.

Second, monetary policy carries dangers. With reduced leverage by banks and reduced consumption by households, both the quantity of money and the velocity of its circulation will fall. This shrinks nominal GDP. For the Fed’s monetary levers to precisely counterbalance this fall is impossible. Anyway, it is a moving target and monetary and fiscal policies interact in complex ways. If the Fed undershoots, this leads to deflation and recession. Deflation rewards savers and penalises borrowers – inflation achieves the reverse. Hence, Bernanke will err towards overshoot. However, the resulting inflation will be difficult to control. Any overshoot cannot be wound back quickly (for example, the average maturity of Treasury debt is currently 55 months).

Third, U.S. government debt is climbing, whilst reduced economic growth makes it harder to absorb consequent claims on future revenue. Increased borrowing by government is a burden on future generations of taxpayers who will face the repayments. The U.S. government has already been borrowing from the future by making insufficient provision against future expenditures. The Financial Statements of the U.S. Government shows the present value of future expenses in excess of future revenue to be vast and rising at $2 trillion per year – $500bn in real terms.

Repayments of recent government loans may help. But these will be overwhelmed by new loans, defaults and calls on government guarantees.

These three problems show that the boundaries for government action will be pushed hard. The U.S. government cannot fulfill its long to-do list from the downturn, and repay increasing borrowings, and meet future obligations for MediCare et al. Yet, political as well as borrowing pressures encourage it to try. Such efforts risk tipping deflation into hyper-inflation, as with Germany in the 1920s.

Seventh: Confused signals. Much has been written in anger about guilty parties being bailed out. Even if there were firing squads on Wall Street, the problem goes deeper.

Government rescue packages may be necessary for economic recovery but they are funded by the taxpayer, sooner or later. A net transfer is made from the prudent to the imprudent and from future generations to this. This is divisive – it is the rich who have gained most from the bubble - and it creates “moral hazard”. Why be careful if you will be protected from any negative consequences of your actions?

Furthermore, government assumes the role of a general financial safety net. But the future funds of most governments are already heavily committed. Government moves to insure against adverse shocks both undermine careful risk assessment – precisely the problem this time around - and create expectations that may be difficult to fulfill next time around.

The eighth and final factor: Stormy international waters. The U.S. malaise has spread around the world.

85% of international trade is in U.S. dollars. Foreigners buy 80% of U.S. Treasury bills. The U.S. dollar is the world’s major safe haven and reserve currency. To keep its factories churning, China and other exporters buy U.S. dollars - effectively providing goods on credit. The U.S. is the world’s main debtor and its dollars provide liquidity to global trade.

All this is of vast benefit to the U.S. but could change. Currently, liquidity and trust need to be restored both within the U.S. financial system and globally. If exporters become more cautious about accepting IOUs from the U.S., then both international and U.S. liquidity is reduced.

The most evident risks come from:

a) A tilt towards the Euro. The Euro is a fractured currency, but the only viable alternative to the U.S. dollar.

b) A big policy shift or social implosion in China. The largest human migration in history (from the Chinese countryside to the coastal cities) is going into reverse and China is already easing back on its U.S. dollar holdings.

Foreign holders of U.S. assets cannot easily dismount the tiger. The tipping point may come in 2010 from the mundane issuance of government bonds. Around the world Treasury calculations show a big uplift in such issues in 2010, with new government spending programmes in full swing and the downturn in tax revenues being felt.

The expansion in bond supply will mean: (i) downward pressure on bond prices (higher yields), and (ii) sufficient supply of non U.S. government bonds that big money can shift from U.S. assets. A lot of parked investment money will be looking for a good home. How much more exposure to U.S. debt will investors want? Of the seven previous reasons for trouble outlined, the odd numbered ones apply more strongly to the U.S. than to most other countries, as does the international factor.

Nobody wants to bring systemic collapse down on their head, but nor do they want to be left holding the dummy. Imagine, U.S. to China in 2015: “Here’s the trillion we owe you. Buy yourself a beer with it.”

Some of the eight factors described may be familiar, but not gathered in such strength or formidable combination. Government actions may counter a few but will have negative impact on most. The situation is ominous. We are off the map in stormy international waters without a compass. The steering and transmission are shot and the engine throttled back, with little fuel. Signals are confused and the tugboat increasingly overburdened.

Lifeboats anybody?

Disclosure: Minor long in EUR, GBP.

Comments

[Jason Rines...:]

"Imagine, U.S. to China in 2015: “Here’s the trillion we owe you. Buy yourself a beer with it.”

Future statement of the week award goes to you Mr. Smelt.

Jan 12 11:05 AM

[kruser53:]

Excellent article.

The Fed was created to stabilize the banking system. It took about 90 years for the "protected" to eat the "protector".

Jan 12 11:45 AM

[Moon Kil Woong:]

My diagnosis.

#9. You seem to be pulling a giant UHaul trailer around called the National deficit around. And in that UHaul you have a bunch of steel beams called the trade deficit. No wonder you run out of gas and haven't moved in a decade (although you rocked back and forth really good in the giant rut hole people call the economy in the last 8 years).

Regarding the transmission, you seem to have a bunch of gunk stuck to it called government lard. But the strange thing about this is it seems to have been growing. I think it is in your fuel tank now.

Which draws my attention to the fuel supply. The Fed has spiked it with sugar. Although you think this is more energy in fact it kills the engine. The fuel won't flow (out of banks and into the economy) and also makes the fuel gummy actually depriving the engine of burnable gas (the fed inflates its balance sheet by encouraging them to leave their money at the fed for interest to help finance its backstopping of debt which leads to monetary contraction/less financial gearing/lower money multipliers). So sure there is more primary money but much less real money churning through the economy as M3 money supply.

But #10 is the doosey. The car is being driven by a drunk Bush Jr. (he's been effectively passed out about 8 years now), a high Paulson (power will do that to you especially when it comes in the form of hundreds of billions of dollars, and a emo Bernake (I think he has a secret death wish for the economy even though he writes how much he loves throwing money at people. It's a love hate relationship in which he is content to hoard cash. It's a security thing. Don't expect any money from a helicopter anytime soon. He ain't Eva Perone).

I can't believe Bernake and Paulson are so stupid. Maybe they are smart and have shorted the market from a Swiss bank account like Paulson shorted mortgage backed derivatives he sold to his clients before. I wouldn't put it past him.

I'm glad the car isn't on a cliff. Because the only thing that is keeping them from driving this car off the edge is it can't move that far.

Jan 12 12:56 PM

[gabe borens...:]

This is the most ridiculous analysis of the current economic status quo to date.
What is the most amazing about this Johnny come lately economic synopsis,that it is reflective of the current consensus which is totally wrong.
On June 3,2005 ,I have predicted the the current economic "turbulance " in an interview with Mark Gilbert(Bloomberg ,London) .
I did not hear any expression of support for my point of view.
Silly me ,on September 18 2008 in an interview with Brian Sullivan (Bloomberg TV),I have reiterated the almost "doomsday" scenario which was received by the business community with degree of skepticism-few weeks later the financial sector started to "disintegrate" and the rest of the economy had followed.
Unlike in the preceding economic cycles ,the FED ,the Treasury ,the Administration and the Congress had been addressing relevant issues with unprecedented "speed" there by deflecting unquantifiable disaster.
The perceived problems are a function of the" lag".
The barometer of the human "misery" ,unemployment, is a lagging indicator reflective of the past errors.
President Obama's proposed economic stimulus(850billion dollars) will enhance the magnitude and the speed of the economic/market rebound.
The TARP and the stimulus ahead amount to almost 1.5 trillion dollars.
Using the multiplier of seven,that amounts to more than 10 trillion dollars of an economic "jolt"-almost 80% of the U.S GDP-a
mind boggling ,record stimulus.U.S economy will be on the way to a rebound by the 2nd qtr of 2009 and it will be on the way to a record expansion by the 2nd half of 2009.
Europe and Asia will lag the U.S and their economies are likely to "slip" as the governments in these geographic zones are not in a position to implement comparative "stimulus".
Dollar will rally to a premium vs Euro-period.

Jan 12 03:06 PM

[AJB7:]

Maybe both Smelt and Borenstein can both be half right. Everyone recognizes the disaster senario at this point, but also the massive and unprecedented magnitude of the intervention response. Perhaps the latter will cancel out the former but still not be enough for economic lift. At least this is what I understand Paul Krugman to be arguing recently.

With all these macro analysis eagles flying about, I'm just a small sparrow. Still, I didn't lose any money in 2008 because I don't try to make the big bets but just listen to the market. Since last summer it's been saying be ultra cautious, which for me is mostly cash. There is time enough to be patient a little longer to see how this all plays out.

Jan 12 10:20 PM

[Simon Smelt:]

Re Gabe Borenstein's comment:
I don't argue that something like the current rescue packages are necessary, particularly to keep the financial system operating. Lot's of interesting discussion at the New Year's American Economic Association meet on this. These moves are countering an extra big down cycle. But, I do argue that all this is at best inadequate to tackle the structural problems that have built up or, likely, making them worse; i.e. they're tackling symptoms, not the disease.
Unfortunately, the long term prognostication for the patient may not prove to be so long in this case.

Jan 13 02:39 PM