George Magnus: We’re Not Out of the Woods Yet

George Magnus, the UBS economist who popularized the term “Minsky moment,” has a thoughtful comment, “The credit crisis: why it is still too early to relax,” in today’s Financial Times.

The article expresses doubts about the beliefs that undergird the current optimism in the financial markets, namely that the credit crisis is pretty much over, that growth in emerging markets will compensate for any slowdown in the US, and that central banks and sovereign wealth funds will forestall any currency disruption. (Note that the FT’s John Authers also voices reservations about the rally today).

I have a sneaking suspicion Magnus could say more about each of his points, but he does a nice job in the space constraints:

Milton Friedman, writing about the role of monetary policy, once wrote: “From the infinite world of negation, I have selected two limitations of monetary policy to discuss.”….Applying Friedman’s language to financial markets, I have three propositions to negate – or at least to question.

The first is that the credit crisis is over. Tensions in credit markets have certainly eased but there remains much that is not yet normal. Deal flow has picked up. Investment grade bond and credit default swap spreads have fallen back from their recent highs, as have US dollar and sterling interbank rates. Banks have been admitting their losses from the credit seizure. Even so, it is unlikely that markets will return to anything like the status quo ante. Confidence between lenders and borrowers remains low. The scramble for liquidity is still ongoing, as evidenced by euro interbank rates, which are still hitting new highs. In a nutshell, reducing debt levels and addressing balance sheet issues have only recently begun. History suggests that the workout consequences in housing and the economy will be protracted.

The second popular assertion stands in stark contrast. It is that the economic consequences of the credit brouhaha will be relatively benign and that global emerging markets will save the day. It is possible. Strong equity markets and the performance of consumer stocks associated with foreign sales, especially in emerging markets, offer proof of this. We could have a two to three quarter slowdown followed by the long-hoped for rebalancing of the global economy, notably between the US and China.

Yet I do not think this is especially likely. Housing, business and financial services generated almost 40 per cent of the growth rate of America’s private sector gross domestic product in the 18 months to June, and over half of the UK’s GDP growth rate. These numbers exclude the secondary effects on consumption from housing wealth. If these sectors are only flat in the coming year, growth will stall while also prolonging credit restraint.

There is no question that emerging markets are in a far stronger financial position. This should certainly help the global economy become less dependent on US growth, but only to an extent. Some, mostly smaller, countries in eas tern Europe and central Asia have large foreign currency liabilities, which could cause problems if low interest rate currencies such as the yen strengthen further as the US dollar declines.

Many countries are commodity exporters whose revenues will suffer as demand from Organisation for Economic Co-operation and Development countries falls. Asian exports are likely to suffer twice: first as a result of weaker OECD demand and then be cause more than half of China’s imports are other Asian exports, which are re-exported. China’s own boom also faces monetary policy questions with the political sensitivity of rising inflation.

Finally, the third proposition is that global capital flows, especially those attributed to sovereign institutions (central banks and sovereign wealth funds), will act as a bulwark against adverse outcomes in the foreign exchange and other markets.

There are several examples of (smaller) SWFs buying stocks or making bids in the US and Europe but these are largely attracting publicity for political reasons. SWF assets of close to $3,000bn are substantial but are only one-sixth of the size of global pension funds. Asset allocation flows are probably conservative. Not many central banks buy equities (yet) and certainly not as a major part of their asset allocation. Sovereign investing is an important new focus but we should not delude ourselves that it will alter economic outcomes.

John Kenneth Galbraith also had the gift of powerful language. Referring to money, he said that: “Over all history it has oppressed nearly all people in one of two ways: either it has been abundant and very unreliable, or reliable and very scarce”. We are in the process of making this transition. Monetary policy faces stern tests of effectiveness as the credit cycle evolves. We need to understand its limitations.

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