Monday, 27 August 2007

Crisis, What Crisis?

Few could have failed to miss the stories in the Press about the turbulence in the financial markets over the past few weeks. The Financial Times has uploaded an interesting interactive graphic that charts the progress of the recent ‘Credit Crunch’ (see graphic). It is interesting to see how a problem in one geographical market spreads into others. What has been even more interesting has been the policy response of the monetary authorities across the world.

The joint response has been a policy of monetary loosening, depending upon the ability of the central banks to act. In the US, the response was to inject a bit of liquidity into the market, coupled with a reduction in the Discount Rate (think of that as the wholesale price of money traded between banks). In Japan, where the scope for interest rate reduction is much less, the Bank of Japan injected liquidity into the financial sector. This was also the response of the European Central Bank, where conditions are different to Japan. In Europe, the real economy needs monetary tightening (through higher rates), while the monetary economy, right now, needs a monetary loosening. The worst of the turbulence now seems to be over, and the Central Bankers are likely to be pleased with the way in which a potentially major problem has been dealt with.

In future terms, two questions dominate. Will the turbulence in the monetary economy bleed into the real economy? It is hard to assess this at the moment. If the turbulence has been contained, then there is an argument that the real economy is unlikely to be greatly affected. If, however, by October - when the true extent of the losses and the identities of the holders of the losses become known - further turbulence is encountered, then there is likely to be a greater chance of the real economy being affected by the turbulence in the financial markets. Further monetary loosening is likely to fuel, eventually, further asset bubbles – either in the stock markets or in the property markets.

One of the reasons why it is hard to see where the losses will fall is because of the opacity of the financial instruments being traded. We can all see the starting point – sub-prime lending to poor credit risks. These were then bundled into a further series of financial instruments. In doing so, it appears that the credit rating agencies rated the instruments according to the probity of the institution packaging the debt (usually good credit risks), and not according to the eventual borrowers (very bad credit risks). When the sub-prime market stuttered through rising defaults, nobody quite knew who was exposed to the market and by how much. This is where an element of panic set in. It is the modern corollary to the Victorian ‘run on a bank’.

This brings us on to the second question – can it happen again? It is reasonable to expect that it can, given the development of increasingly exotic financial instruments and the interconnected nature of modern financial markets. In this respect, financial turbulence is the consequence of globalisation – turbulence spreads much faster and much further afield nowadays. However, there is also a much deeper future issue buried in this question that is all to do with where the US stands in the world.

In an interesting article in The Business (see article), Bill Jamieson correctly points out that the lead agency in dealing with the recent turbulence has been the US Federal Reserve. However, one wonders how long that might continue. Financial turbulence is often the result of large scale changes in the world economy. An interesting example here is the Sterling Crisis of 1947-49, where the financial markets adjusted to Britain no longer being a world power. If we are in a period of relative US decline – possibly through the rise of China and India, then, at some point within the next five to ten years there may well be a significant run on the US Dollar analogous to that experienced by Britain in the 1940s, as the financial markets adjust from the one paradigm to another.

In this vision of the future, the market adjustment is likely to be substantially greater than the recent one. We need to remember that on 16th September 1992 (‘Black Wednesday’), the UK Treasury spent £27bn in reserves in three hours to fail to support the Pound in the ERM. It is possible to envisage a scenario where the Fed. simply does not have enough money – and the US enough friends in East Asia – to support the Dollar. In which case, recent events take on the nature of an inconvenience rather than a crisis.

I wonder how many global companies have priced that risk into their business models.

No comments: