Martin Wolf, the Financial Times’ highly respected chief economics commentor, weighs in with a pretty pessimistic piece tonight. This makes for a companion to Peter Boone and Simon Johnson’s Doomsday cycle post from yesterday.
Let us cut to the chase of Wolf’s argument:
Now, after the implosion, we witness the extraordinary rescue efforts. So what happens next? We can identify two alternatives: success and failure.
By “success”, I mean reignition of the credit engine in high-income deficit countries. So private sector spending surges anew, fiscal deficits shrink and the economy appears to being going back to normal, at last. By “failure” I mean that the deleveraging continues, private spending fails to pick up with any real vigour and fiscal deficits remain far bigger, for far longer, than almost anybody now dares to imagine. This would be post-bubble Japan on a far wider scale.
Yves here. Notice he associates success and failure with polar options. But how can you “reignite the credit engine” when the financial system is undercapitalized even before allowing for the need to take further writedowns? The IMF has found the converse in its study of 124 banking crises, that purging bad debt is a painful but necessary precursor to growth. So I fail to understand how Wolf envisages that “skip Go, collect $200” of releveraging quickly comes about. And in fact, it turns out that Wolf’s “success” is a straw man:
Unhappily, the result of what I call success would probably be a still bigger financial crisis in future, while the results of what I call failure would be that the fiscal rope would run out, even though reaching the end might take longer than worrywarts fear. Yet the big point is that either outcome ultimately leads us to a sovereign debt crisis. This, in turn, would surely result in defaults, probably via inflation. In essence, stretched balance sheets threaten mass private sector bankruptcy and a depression, or sovereign bankruptcy and inflation, or some combination of the two.
I can envisage two ways by which the world might grow out of its debt overhangs without such a collapse: a surge in private and public investment in the deficit countries or a surge in demand from the emerging countries. Under the former, higher future income would make today’s borrowing sustainable. Under the latter, the savings generated by the deleveraging private sectors of deficit countries would flow naturally into increased investment in emerging countries.
Yet exploiting such opportunities would involve radical rethinking. In countries like the UK and US, there would be high fiscal deficits over an extended period, but also a matching willingness to promote investment. Meanwhile, high-income countries would have to engage urgently with emerging countries, to discuss reforms to global finance aimed at facilitating a sustained net flow of funds from the former to the latter.
Yves here. Unfortunately, not only does it require “radical thinking” but also political consensus in a US that is badly divided, and not simply along party lines. Class warfare is in the air, and the idea of any large scale spending program will raise even more acute “But what about my share?” problems than usual.
We see a stark reminder of outcomes that will strike ordinary people, correctly, as unfair in the Wall Street Journal’s “Lending Falls at Epic Pace“:
U.S. banks posted last year their sharpest decline in lending since 1942, suggesting that the industry’s continued slide is making it harder for the economy to recover.
While top-tier banks are recovering at a faster clip, the rest of the industry is still suffering, according to a quarterly report from the Federal Deposit Insurance Corp. Banks fighting for survival, especially those plagued by losses on commercial real estate, are less willing to extend loans, siphoning credit from businesses and consumers.
Besides registering their biggest full-year decline in total loans outstanding in 67 years, U.S. banks set a number of grim milestones. According to the FDIC, the number of U.S. banks at risk of failing hit a 16-year high at 702. More than 5% of all loans were at least three months past due, the highest level recorded in the 26 years the data have been collected. And the problems are expected to last through 2010.
FDIC Chairman Sheila Bair said banks are “bumping along the bottom of the credit cycle” and that the number of bank failures in 2010 will likely eclipse the 140 recorded last year.
Yves here. There are a few problems with this picture. First, consider the throwaway “top tier banks are recovering faster” remark. Ahem, the 19 banks subjected to the stress tests hold 70% of deposits, which somewhat confounds the picture. However, it also fails to factor in the role of the implosion of the securitization market (although Freddie and Fannie have moved in a massive way as a stopgap on the housing front). So the actual contraction in credit extension, when the impact of the fall in securitization is factored in, is almost certain to make the picture even worse. And securitization, while it did include riskier corporate lending (collateralized loan obligations), the bulk of the volume was consumer and small business credit (recall that home equity and credit cards were a significant source of small business financing).
So the little guy is hit disportionately, and in cases, unfairly (I’ve heard stories of both very affluent people who used credit minimally who had credit lines cut, as well stories both in the press and recounted personally of people who were simply in the wrong zip codes, who were treated as credit risks due to the severity of area housing price declines even if they had largely or entirely paid of mortgages).
And of course, we have the elephant in the room, the seeming inability to come up with sensible mortgage modification programs (again, to a significant degree, due to the shift to securitization making it virtually impossible for the newfangled mortgage machinery to do anything on an individual basis, like assess creditworthiness, plus seemingly insurmountable intercreditor obstacles for borrowers who have second mortgages or HELOCs). The wee bit of bright light here appears to be that banks are getting more amenable to short sales.
Now the little guy versus big business distinction (where credit is more freely available) might be acceptable if there were evidence of shared sacrifice. But there is none. Wall Street bonuses are the most egregious offense, but there has been perilous little in the way of serious cuts in executive pay (John Mack’s zero bonus for three years running is a welcome and rare bit of symbolism, but even so, with the rest of the industry at the feeding trough, the austerity does not go very deep into the firm overall). And the financial press recounts on almost a daily basis the desperate efforts of banks to find new ways to
fleece customersextract fees, which further stokes the resentment of an aggrieved public.
With the private sector debt overhang as great as it is, I doubt there is a way out of our mess that does not involve a period of debt restructuring and writeoffs. That process, no matter how adeptly handled, results in dislocation and has a chilling effect on bystanders (think of what it does to your mood to watch your neighbor’s house burn, even if you are unscathed. And mind you, I said neighbor, as in immediate neighbor, not the schadenfreude of seeing banksters or others seen as undeserving get their comeuppance).
Back to Wolf:
Unfortunately, nobody is seized of such a radical post-crisis agenda. Most people hope, instead, that the world will go back to being the way it was. It will not and should not. The essential ingredient of a successful exit is, instead, to use the huge surpluses of the private sector to fund higher investment, both public and private, across the world. China alone needs higher consumption.
Let us not repeat past errors. Let us not hope that a credit-fuelled consumption binge will save us. Let us invest in the future, instead.
I had a little e-mail chat with Swedish Lex, who offered his take:
The implicit conclusion of what Wolf and Johnson write is that we going forward need dirigiste economies and national and regional scale of types and magnitude that we have not seen before (or at least not in a very long time). In addition, the dirigisme would have to be closely co-ordinated globally.
I agreed with his reading of their views and noted:
I don’t see how we get close coordination. I had a talk with someone in from Hong Kong today, he is quite alarmed at China’s bullheadedness, wanting what it wants and devil take everyone else.
Plus we will not get dirigisme until the hold of the banking sector is broken. It will take a bigger bust to do that.
Swedish Lex interestingly sees another possible brake that may become operative prior to another bubble/bust cycle. He believes that the EU has much less tolerance for underwriting zombie banks than the US. The EuroBanks have written off less in the way of losses than their US peers, are also exposed to any EU sovereign debt defaults, and yet the biggest are still crucial parts of the international capital markets infrastructure (and therefore still tightly coupled to the very biggest US/UK firms). While any EU sovereign debt defaults could morph into a full blown crisis, the EU responses to the joint sovereign/bank debt overhang could lead to more radical changes in EU banking rules and practices that could blow back to the very biggest US banks in unexpected ways.