October 13, 2008 | posted by Michael Baxter in credit crunch | comments (1) |

As the banking crisis turns to a real world economic recession, the blame game gathers momentum. Clearly bankers are being held up as the villains of the piece, and short-sellers, well, they are just evil.

The trouble is, when we look for someone to blame, we are in danger of missing the point. In some ways we live in a democracy gone mad. Politicians dance to a tune played the media, and the media just reflect what we are already thinking. The media have not cooked up the backlash against bankers and short-sellers, rather they have sensed the nation’s mood, and re-enforced it.

But the true cause of this crisis runs far deeper than the errors of crazy bankers. It even runs deeper than the national error, which was to assume house prices always go up. There were underlying forces at work, and it was these which created the current crisis.

Here is a brief summary of what really lies behind this crisis:

First off, there’s the demographic time bomb. In 2011, the first of the baby boomer generation will reach 65. By 2013, it seems the UK’s working population will contract.

Secondly, we are in fact already eight years into a stock market bear run. The FTSE 100 reached its all-time high on the penultimate day of 1999. Although other indices hit new highs earlier this decade, for the developing world this decade has been poor for the performance of equity investment.

This in part lay behind the surge in property prices, with many seeing their buy-to-let portfolio as their pension. It also led to the phenomenon of under-utilized homes. Over six million homes in the UK have two or more spare bedrooms. This is surely because home-owners saw the space as a good investment, maybe an essential investment in light of pension worries and poor stock market performance.

Thirdly, the view that the global economy is suffering from an explosion in debt, is a myth. It is true that some countries, namely US, UK, Australia, Ireland, Spain and Denmark, have seen the emergence of a debt bubble. But on a global basis, there has been too much saving. Central bankers fretted about this earlier this decade. The Fed held interest rates to 1 per cent for as long as it did, for precisely this reason.

Fourthly, as some countries blame the Anglo-Saxon economies for this crisis, don’t forget that earlier this decade, as the likes of Germany, France and Italy played with recession like a child with his favourite toy, spending from US and the UK at least enabled these countries to export their way to recovery. Without these exports, the Eurozone would have suffered a far deeper recession.

For that matter, without US consumers, the Chinese economic growth miracle would have been a lot less dramatic.

Fifthly, remember banks and their management were responding to the demands of their shareholders. These shareholders were often pension funds which, after years of seeing appalling stock market performance, at a time when the fears of a demographic time bomb created additional fears, wanted to see rapid growth. The short-termism of banks was really the short-termism of shareholders, which itself was created by a pension crisis in the making.

The worldwide savings glut suggested the possibility of global over-capacity. This may had been caused by the combination of technological innovation and globalisation. The 1930’s depression also followed a period of rapid innovation in technology and production techniques. It seems both periods had this in common: global demand had not been given time to adjust to changes in potential supply.

Sixthly, it is possible that uneven distribution of income, both today and in the 1930s, exacerbated the problem of demand not keeping up with capacity.

In some ways, it seems the conditions of economic crisis have been with us for all of this decade – surging debt in the US and certain countries meant the economic slowdown one would have expected did not occur.

Now the world is changing. The dollar and pound have fallen dramatically, and the rest of the world can no longer rely on exporting to the US and UK. Meanwhile, China has got no choice but to let the yuan appreciate; at the same time, there is evidence Chinese consumers are spending more, and saving less. This will help redress the balance.

The savings glut was also caused by massive trade surpluses in certain oil exporting countries. The imminent fall in the price of oil will help redress that balance.

If you really want to know what lay behind this crisis, it was the way the world had gone so far out of balance, with some countries spending too much, others saving too much. This was partially caused by the pace of technological innovation and globalization creating a time lag as the world learnt to adjust.

The current crisis is correcting all this. Providing banking collapse can be avoided, the final result will be a global economy built on more sustainable foundations.

But as each crisis passes, the next begins.

In Europe, the demographic problem is set to become even more serious. With the belief that house prices always go up finally exposed as a myth, savings ratios will rise. This will create the danger of aggregated demand being too small.

This crisis also marked the first stage in the loss of US hegemony. Many more stages will follow, and each stage will come with a new set of dangers.

September 29, 2008 | posted by Michael Baxter in credit crunch | comments (1) |

In yesterday’s Sunday Times,  the august newspaper’s economics editor David Smith headlined  “if this is the bust,  why wasn’t it preceded by a bigger economic boom ?”

As you know,  bust is the price we pay for too big a boom.  But Mr Smith,  who we have previously said must be hoping to win the award of most optimistic economics writer of the year,  doesn’t see it like that.

“In the run-up to the last recession,  in the early 1990s the economy was characterised by runaway growth in consumer spending, ” he said,  then added  “ this time,  however,  one striking but unappreciated feature of the economy has been the absence of a consumer boom”.

Is he right?  Are we really seeing bust without boom?  Maybe,  therefore,  we can all assume all this talk of crisis,  is overdone.  A few banks got their sums wrong,  but that is it.  The slowdown will end in no time.

It seems though,  that the above argument really hits a quite different nail on the head.  It explains how policy makers got it all so horribly wrong.

It is true that consumer spending did not rise so fast in the nineties.  From 1996 to 2000,  year on year consumer spending rose by between 3 and 6 per cent a year.  That was impressive,  but not unprecedented growth.

Since 2000,  consumer spending has slowed,  ranging between a growth rate of 2 and 4 and half per cent a year so far this decade.

House prices,  of course, shot up during this period.  Ergo,  as consumer spending only saw modest rises during their period,  there is no significant link between house prices inflation and consumer spending growth.

This,  in turn,  justifies the policies of governments and central banks.  Talk of a debt bubble,  is a myth.

There is one snag with this argument.  It flies in the face of common sense.  If economic data does not support what seems to be blatantly obvious,  one is left concluding there must be something wrong with the data.

Explain this.  While consumer spending saw only modest rises,  the savings ratio in the UK plummeted.

So rising house prices may not correlate with changes in consumption,  but they do correspond with the falling saving ratio.  It is easy to guess why.  The logic goes like “I don’t need to save,  my saving is in the form of the rising value of my property.”

And here is another explanation as to why consumer spending did not rise so fast this decade.  It was already too high.  There should have been a crash in consumer spending in 2000.  Instead rocketing house prices stopped this crash from occurring.

We may not have had a massive boom this decade,  but we have seen the longest ever boom, over 16 years in length.

There was a debt bubble.  And the bubble maintained consumer spending at a level that was too high.  But the subtlety of this meant that central banks just didn’t spot the danger.

August 26, 2008 | posted by Michael Baxter in credit crunch | comments (2) |

As the credit crunch passes its first birthday, many have looked back in anger at the events that created the credit crunch and have looked for someone to blame.

Others have looked forward with frustration. Why doesn’t the government do more, they ask?

Others bury their heads in the sand, and after proclaiming the imminent end to the credit crunch, jump with joy over news that some believe house prices could rise by 30 per cent over the next few years. Oh goody, they say, the good times are returning.

Yet, through all this recrimination and ill-founded hope, the real lesson gets forgotten.

The banking practice that preceded the credit crunch was not all bad. Greed was not just restricted to the banks. The real error was nationwide in its scale – perhaps even worldwide. The real error tells us why crowds can get it wrong. If most people are sure something is true, it does not necessarily mean they are all right.

The danger is that we still haven’t got it.

There are two theories regarding recessions. One sees a recession as a lost opportunity. If the potential for economic growth is 2 per cent a year, and the economy slows to zero per cent one year, then that potential is lost, for ever. The economy will always be 2 per cent poorer than it could have been.

The trouble with that theory is that it assumes growth is something that just happens. Growth, of course, requires innovation. If we stopped innovating, then sooner or later we would reach a point at which there is no point in investing in more machines, other than to replace those that are getting old. We would have reached full capacity. Economists who assume growth can continue at 2 or perhaps 3 per cent a year indefinitely, are implicitly assuming innovation just happens. It’s like magic. Whoosh, there’s some innovation. And boom, there’s some more.

But the truth is, innovation only happens if there are forces at work that create it. Innovation is the result of competition, it’s the result of practice – if you do something enough times you get better at it – and innovation is the result of investment.

Innovation applies to the little things, as well as the big things. So, coffee shops innovate by introducing a standard-sized lid for all takeaway mugs, regardless of size.

Then there are the ways people are organized.

In the United States from 1995 to 1998 there was a sharp rise in the rate at which labour productivity increased. This underpinned US economic growth – which averaged 4 per cent a year during this period. It has been estimated that a quarter of that increased productivity came from retailing, and as Bradford C. Johnson in a McKinsey Quarterly article once said: “More than half of the productivity acceleration in the retailing of general merchandise can be explained by only two syllables: Wal-Mart.”

Here is another example of innovation: As Alan Greenspan said in his book Age of Turbulence, there was a time when negotiations between suppliers and retailers were like a game of poker. Neither side willing to reveal their plans. For the suppliers, this often left them in the dark. How much should they produce. What inventory levels did they require? These days, suppliers often have direct links to parts of retailers’ stock control systems. They know when their customers’ stock is getting low, and they automatically send over more product. (See Age of Turbulence pages 46 and 490.)

Bold banking practice had much to do with the innovation that occurred. It funded investment, it funded new business ideas, and the world was better off as a result. Really better off. Not just in a paper sense, but in the sense that we produced more goods and services than ever before.

It is actually known as endogenous growth. Growth that comes from innovation that is a part of the economic system. Not innovation that occurs by magic – or exogenous growth, but innovation that occurs as a result of the right type of business practice.

And in the theory of endogenous growth, the odd recession from time to time is a good thing. It is like a clean out.

Right now, the government and central banks are busy trying to right the mistakes of the late 1990s and early noughties. They are trying to get the money markets working again.

Talk is that the government is mooting the possibility of gradually removing stamp duty on house purchases – that will get the property market moving again.

But a resurging property market is not the answer. Surging house prices have nothing to do with wealth creation. At best they redistribute wealth, at worst they create an illusion.

Yet still, many call out for the government to rescue the beleaguered property market. Presenters on GMTV ask with incredulity, why the government doesn’t slash tax on petrol and cut stamp duty. They look at banking practice and call for bank lending that is based on good old fashioned values, a return to Captain Mainwaring type bank managers.

And that is the real danger: the danger we solve the symptoms, and ignore the deeper ill; the danger we bite the very hand that could feed the economic recovery.

Even now, some seem to want to measure economic prosperity by how much house prices are surging. The truth is, the last few years have seen a boom built on air. A boom built on borrowing. A boom underpinned by the false belief that house prices only ever go up.

Many would-be entrepreneurs were sucked out of their wealth-creating activities and joined the buy-to-let bandwagon. Investment into areas that created wealth became yesterday’s idea.

The real greed was with all of society, not just the banks. It was the greed that led all those that could afford it to jump into the property boom, exaggerating its effect. It was the greed that led to TV programmes such as Location, Location, Location.

The banks were at fault because they should have known better. But the real problem was not just the banks. Let he who is without economic sin cast the first economic stone. Before we jump on to the anti-bank bandwagon with too much gusto – maybe we should all pause and look a little closer to home first.

August 6, 2008 | posted by Michael Baxter in credit crunch | comments (0) |

During the credit boom it was difficult to get behind with debts. At least it was difficult to get behind if you owned your home. All you had to do was use the rising value of the equity in your home to pay off credit card bills.

But as the credit crunch bites, and house prices fall in value, this option is being removed. And so all eyes turn to the data on insolvency, the level of loans in default, and loans in arrears.

Yesterday, the FSA revealed its own take on the situation with data on lending, arrears, and possessions.

The good news, there was no rise in the number of new cases of loans in arrears. But the total number of loans in arrears grew by 15% in the year to 2008 Q1. “This indicates,” says the FSA, “that borrowers in arrears are staying in arrears for longer periods of time than previously.”

Numbers of new possessions grew significantly in late 2007 and early 2008, with 9,152 new cases in Q1, a rise of over 40 per cent on a year earlier.

The FSA also turned its attention to the size of mortgages relative to the value of homes they are secured against.  It said: “Significantly fewer new loans have a LTV (loan to value) of more than 90 per cent, reducing from a peak of 15 per cent of new lending to 10 per cent in 2008 Q1. The use of combinations of high LTVs and high income multiples has also declined to under 7 per cent of new lending.”

As for subprime-type lending. The FSA said: “Loans to borrowers with an impaired credit history represented 2.3 per cent of new lending in 2008 Q1, compared to 3.6 per cent a year earlier.”

The big drawback with these figures is that they relate to the first quarter of this year. On the face of it they look bad, but not all that bad. The snag is we know things have got worse since then, so we have a long wait before we get the FSA’s take on the quarter just gone.

July 29, 2008 | posted by Michael Baxter in credit crunch | comments (0) |

The IMF now expects total losses related to the credit crunch to hit $1 trillion. Meanwhile, Merrill Lynch has announced yet another write-down, and plans to raise yet more money.

They keep saying the crisis is nearly over. The fat lady seems to be reaching her finale, and then, all of a sudden, she turns the page over and begins a new song of woe.

Cast your mind back to January. At the time banks must have thought all their nightmares were coming true at once. Now they must look back on the beginning of this year as the good old days.

Back in January, the general feeling was that losses related to the credit crunch would come to around $300bn. Some estimates put it at nearer half a billion.

Merrill Lynch made total write-down in 2007 of $22.1bn, and in January its boss John Thain said: “I don’t think you should anticipate any further problems of this magnitude.” He added, “There would have to be something incredibly bad out there to have this happen again, and our whole goal is to get 2007 behind us.”

It’s a bit like that scene in American Werewolf in London, when the main character seemingly wakes up from a nightmare, only to realize it’s not over. He is having a dream within a dream. It’s a trick Hollywood is now well practised at playing, but back then it gave the audience quite a shock.

Well, that’s what happening with the banks today.

It was less than two weeks ago when the bank last announced losses. In the second quarter it lost nearly $5bn, and in revealing its latest quarterly loss the bank found itself in the unenviable position of suffering four straight quarterly losses. So far it has lost $19.2bn, and total write-downs come in at around $40bn.

Then yesterday, as if all that wasn’t bad enough, it revealed yet more write-downs. This time $5.7bn.

And consider this:

When it revealed its last set of quarterly results – ah, that was July 17, it said it was putting a valuation of $11.1bn on CDOs with a nominal valuation of $30.6bn. So that was a big write-down on nominal value – and no one was thrilled by that.

But, just as Harold Wilson said a week is a long time in politics, it appears 12 days is a long time in the world of CDO valuations, because the bank has now sold those same CDOs to Lone Star Funds for just $6.7bn.

And while it was at it, the bank revealed plans to raise another $8.4bn.

Given this seemingly never ending saga of losses, it is no surprise to hear the IMF now reckons total losses from the credit crunch will come to $1tn.

Actually, it’s not that much of a new announcement from the IMF. In April it had estimated that subprime losses would come to $945bn, but back then it was different.

Back then the IMF was really looking at a worst-case scenario. Most analysts thought it was being unduly pessimistic.

But, at the time of writing, losses to date come to just short of half a trillion dollars. So, all of a sudden, that dreadful $1 trillion mark is looking horribly likely.

The IMF said: “At the moment, a bottom for the housing market is not visible. Stemming the decline in the US housing market is necessary for market stabilisation as this would help both households and financial institutions to recover.

“The growing concern is that, with delinquencies and foreclosures in the US housing market rising sharply, and house prices continuing to fall, loan deterioration is becoming more widespread.”

Maybe the time to worry though is if someone says something like: “I don’t think you should anticipate any further problems of this magnitude. There would have to be something incredibly bad out there to have this happen again, and our whole goal is to get 2008 behind us.”