Economic Review 2008

December 24, 2008

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The failure of the global capital markets that began in mid-2007 became systemic through 2008. Not surprisingly, economic activity slowed dramatically in most of the major industrial countries.  At the end of the year, the output of most countries was contracting or about the contract.

The situation deteriorated so swiftly that the world’s central banks and their governments went into full damage control.  Remarkable as this meltdown was, equally remarkable was the coordinated response of the world. Facing a crisis, there was little debate, except for small details.

While the Bank of Canada was responding appropriately, the only government off-side was Canada, whose Prime Minister decided to try for cheap political advantage. This gambit blew up in his face and the anticipated budget is likely to join the fiscal norms of the industrial world by being stimulative.

While we will discuss  how we got into this sorry mess below, let there be no doubt that the financial system, that is the banks, needed to be rescued, and fast.  A modern technologically intensive economy [meaning real people creating real goods and services] cannot trade effectively unless it is sitting on the platform of a smoothly functioning financial system.  It is the lubrication of the marketplace.  Without massive intervention, the financial system would have effectively collapsed and taken the world’s real economies down with it – into distress of extraordinary degree.

Are these bank rescues, bailouts, going to partly reward stupidity, greed, incompetence and some instances of fraud? Yes, but there is no choice. Some of this help will be wasted and some misdirected to the undeserving.  The government of the United States was so taken unawares that it responded with pure crisis management, with no pretense of a plan. And the Secretary of the Treasury is a former Wall Street boy who wanted to tread gently with his old colleagues. This of course  is a recipe for waste and confusion.

The entire argument is reduced to this fact: the financial system cannot be allowed to fail, meaning its major for-profit banks cannot fail.  That is why banks are highly regulated, or supposed to be highly regulated.  And that is how we get into this fiasco.

The great excuse machine in now in full gear.  The financial institutions and their armies of MBA advisors are now claiming that this disaster was impossible to anticipate, like a meteor strike. Yet a financial crisis was anticipated and warnings sounded. The logic was inescapable.

Former students will remember that for at least 6 years, we have had to argue that the course of action of the US economy was unsustainable.  Too much public debt, on top of growing private debt alone dictated a day of reckoning.  President Bush was clearly incapable of understanding the gravity of the situation – actually any situation – and was never prepared to ask for sacrifice for any public purpose, including multiple wars. His original tax cuts removed any margin for error; as was said at the time: “What if something goes wrong”.   A lot was about to go wrong.

No matter the excuses and whining,  the danger of a financial disruption was long known. Massive borrowing, cheap money and declining regulation all contributed to this inevitability. Indeed, for more than five years, the course notes have noted that the newly-formed global capital markets were poorly regulated and that there was a danger of imprudent borrowing being facilitated by the seamlessness of the international capital markets.

What was unknown and difficult to anticipate was the timing and the nature of the crisis. Would it be  sudden and sharp, or slow and relentlessly insidious. And of course, what would the scale of the reckoning be?  Ah, yes, the scale.  That was truly unexpected.

Perversely enough, it is indeed preferable that the crisis is abrupt and deep. Since it had to come, better fast and unambiguous. Otherwise, the remedies would have been long in coming – resisted by every vested interest on earth. Fortunately, that horror has been averted. After all, the degree of this disruption contributed greatly to the election of Mr Obama. After eight lost years, a US President who has discernible intellectual function is a major bonus.

The deregulation of the US financial markets has been underway for a long time – sparked by President Reagan.  It was part of general trend to deregulation. Soon to be lost was any sense that the financial players should not be treated like other industries. Other industries can fail, while banks cannot.

Against the backdrop of falling regulation, the banks went on a binge of innovation, creating a truly toxic product – subprime loans [including Alt A loans].  In doing so they violated the first rule of banking, presented to every former macro student: never lend money to people who need it! Red flags flying everywhere. Then to add gasoline to the fire, they broke the incentive to document how poor the borrowers really were.  By securitizing the loans, the lender passed the loan onto someone else, having pocketed a management fat fee. Warning, warning, danger, danger! this way disaster lies.

But what were investors thinking? What were the banks thinking?  Why did they not know that they were about to blow themselves up? Alan Greenspan, the near perpetual head of the Fed Reserve resisted financial regulation precisely because he expected their self-interest would guard them from danger. It is the great justification for markets.  But of course, people behave stupidly [surprise, surprise], they forget to do due diligence, they respond to the short term and forget the long term. they get greedy. They routinely believe that the laws of economics can be superseded. Keynes, of course, understood this.

Admittedly, making a reasoned judgment about securitized debt [credit swaps, derivative contracts] was render more difficult as the securities themselves were wrapped up in complex legal language and even more complicated mathematics. What it actually meant or contained was never clear. Some issues came with thousands of pages of documentation. Who checked? Surely someone was checking? Of course, only a cynic would suggest that the complicated language was a smoke screen to make it difficult to conduct due diligence, rather than as a precise parsing of risk.

The industry of course said that by pooling risk individual risk fell. Apparently that meant that when something goes wrong we all fail together.  Keynes also noted that so long ago.

Indeed, as the failures became manifest, the fact that the banks literally did not know exactly what they held and how much was toxic merely added to the panic. Investors hate uncertainty. and this was uncertainty to a bizarre degree.

Now it turned into a comic opera. Everyone starting “insuring” everyone else’s loans through even more complicated means [credit swaps, etc]. AIG for example blissfully takes on massive obligations against loan defaults. And then the herd began to run. The US tendency to go over-the-top on everything came into play.  Wall Street was a model to the world.  The big global banks got on the  bank wagon.  Move quickly to take a position before the advantage was lost. No time to think.

[Canadian banks  were too “small’ to play with the big boys in the world, and ended up with literally little junk. Pity that so are so small. ]

As investors lost their wits, they began to believe that the risk reward relationship was no more. Even though competitive conditions were increasing everywhere and technology continued to cascade in unexpected directions, the risk of failure was “thought” to be declining. The risk premium between safe securities, like US treasuries, and private bonds shrunk.  But that violated the economic principle that risk is a cost that was be understood and paid for. Logic now went on a vacation.

Unfortunately, this disaster hit with the US economy already vulnerable. Barely recovered from the internet/dot.bomb bubble, US public finances are out of control. Employment growth has been weak most of the decade. Tax rates are below those that can sustain a modern state. California, of all places, is in a fiscal nightmare. Healthcare expenditures are proportionately the highest in the world, with life expectancy far from the highest.  And there are other issues. This of course limits America’s ability to recover quickly, and consequently affects the entire world.

China, India, Russia and the European Union all face their own heavy challenges.

Canada as a major trading nation is powerfully affected by the distress of its customers. The Canadian economy through much of 2008 saw high job growth, with slowing economic activity. Its financial system has suffered little in relative terms. Its public finances remain prudently managed. Canada remains what it has long been, a small, conservative and properous society, on the margin of the world.

This commentary will look forward to 2009 and beyond in a posting just before the New Year.  Commentary on innovation  and economic updates will begin in January.