Emerging Markets in the New World Disorder

By Chris Mayer
Baltimore, Maryland

In horse racing, a match race is when two horses race against each other. One of the most famous such races happened at Pimlico, when Seabiscuit beat War Admiral in November 1938.

In markets, one of the most watched and ongoing match races is the one between Emerging (or developing) Markets and Developed Markets. The former include China, India, Brazil and others. The latter include the US, the EU and Japan. Which one do we bet on and when?

It’s a particularly good question now, as we pick through the smoldering ashes of the 2008 bust. Emerging markets have had a hot 10- year run, even if you include the crackup in 2008. In fact, even if you had invested in the MSCI Emerging Markets ETF (NYSE: EEM) on Jan. 1, 2008, you would be sitting on a profit today. By contrast, the S&P 500 Index has delivered a double-digit loss over the same timeframe.

The emerging markets have snapped back surprisingly quickly. As Jonathan Anderson, a UBS strategist put it, “Not even the worst economic crisis in the postwar era has been able to derail [them].” In financial markets, ideas, like thoroughbreds, run hot and cold. Past performance doesn’t necessarily decide the issue any more than it does in horse racing. But it turns out there is a pretty reliable way to handicap the race between Emerging and Developed Markets.

The “handicapper” in this case is the aforementioned Mr. Anderson, who wrote about his findings in the Far Eastern Economic Review. His title, “Emerging Markets Poised to Perform,” hints at his conclusion.

It all comes down to those old financial constructs called balance sheets. In essence, a balance sheet shows you what you own versus what you owe. These are snapshots in time, a measure of financial health, like an EKG of one’s heart rate. You can often spot trouble here before it becomes fatal.

In my investment services, I always seek out companies with strong balance sheets – the sorts of companies that own much, but owe little. Enterprises like theses have the ability to withstand adversity better than those with weak balance sheets. A strong balance sheet also means that a company can fund its growth independently and more securely, without having to rely on fickle lenders.

As investing star, Martin Whitman, wrote in his most recent shareholder letter: “Don’t invest in the common stocks of companies which need relatively continual access to capital markets, especially credit markets… Even the strongest, best-quality issuers can be brought down, or almost brought down, if they continually have to refinance.” Unfortunately, many investors learned this lesson the hard way during last year’s severe credit crisis.

As it turns out, balance sheet strength is also very important for entire nations. But that’s hardly a surprise. Countries that owe a lot of money tend not to grow as much or as reliably as those with healthy balance sheets. Anderson created a “stress index” to measure the financial health of entire nations. A country with high debt levels and deficits earns a high stress index score. He then plotted this index (inverted) against a rolling average of GDP growth, a rough measure of economic growth.

Guess what? There’s a close connection between the two.

So one way to explain the growth of emerging markets is to consider the strength of their balance sheets. When they have healthy balance sheets, they grow faster than when they have weak balance sheets.

You can see that the last time the emerging markets had a long stretch in the sun was in the 1960s and 1970s. Emerging markets grew 5% or better. As Anderson notes, not a single emerging market – not Africa, not even the Soviet Bloc – failed to post 5% annual growth during this time. And you’ll also note that the balance sheets were healthy.

As a result, emerging markets sailed through the first global oil shock in 1973-75 without much trouble. The developed world, by contrast, suffered the pain of a deep recession. Investors who stuck with their emerging market stocks throughout this period reaped big rewards.

According to Anderson, “Between 1965-1980 the dollar-adjusted return on nascent equity markets in Mexico, Hong Kong, Taiwan, Brazil, South Africa and other lower-income nations ran into the hundreds of percent – while indexes in the US and Europe were essentially flat over the same 15-year period.”

Of course, as I say, these things run hot and cold. The emerging markets “imploded” after the 1980-82 recession. A dozen different countries reported inflation rates north of 100%. As Anderson points out, 20 currencies lost 50% of their value each year. From 1980-99, emerging markets struggled mightily and barely grew. And as you see from the chart, their balance sheets went south as well.

Emerging Market returns during this period were poor overall. A dollar invested in emerging markets in 1990 was still worth only about a dollar 10 years later. In 2000, though, the game changed again. Emerging markets opened up. They cleaned up their debts. And the emerging markets went on a tear that continues today.

In general, emerging markets still have healthy balance sheets today. In fact, they are as strong as they’ve been in 50 years. At some point, that will swing the other way, as these things always do. At some point, there will be too much debt and too much leverage. But for now, that condition seems a ways off.

As Anderson concludes, “All the preconditions are in place for a protracted period of strong economic growth.” He guesses 5-6%, which would crush the Developed World’s growth rates. In fact, the superior (and diverging) growth rates of the Emerging economies are already very visible.

First up, take a look this graph, from The Economist, which shows the industrial production of emerging Asia compared to the United States.

Looks like Asia is recovering pretty well. The chart above clearly illustrates the “decoupling” that became such a hot topic of discussion last year. The idea was that the Emerging markets would not necessarily follow lockstep with the Western countries.

The Developed World suffers through what Richard Koo, the chief economist at Nomura Research in Tokyo, calls a “balance sheet recession.” The Western world suffers from too much debt. That fact shifts the focus from making profits to repaying debt, according to Koo. Debt repayment will continue until the West repairs its balance sheets, a process that takes years to correct, as Japan’s long recession shows.

So the same dynamics that make emerging markets look good, work in reverse for the Developed World. According to Anderson’s model, the stressed balance sheets of the Developed World predict slow growth.

As investors, then, we’ll have to continue to look to the emerging markets for growth. The market never ladles out its rewards evenly, though. To drill down further, the big winner is really Asia and its big markets of China, India and Indonesia.

Anderson estimates that these regions could grow 7% or more annually, well above the tepid rates of developed markets and better than most emerging markets. “This is a very hefty gap,” he writes, “and one that is very likely to continue to reward investors who take advantage of the opportunity.”

How the Irish Can Save Civilization (Again)

In three weeks’ time, Ireland will, for a moment, hold the fate of Europe in its hands. Through a quirk of Irish constitutional procedure, on Oct. 2 the Republic of Ireland will be the only European Union nation to hold a referendum on a treaty to revamp how the EU, home to half a billion people, does business. The Lisbon Treaty, therefore, will stand or fall on the votes of perhaps one and a half million Irishmen and women.

From the perspective of Brussels, this is grossly unfair—a miscarriage of democracy masquerading as democracy. The Irish have stymied the denizens of Brussels’ European Quarter before, most recently the first time they voted against the Lisbon Treaty last year.

Back then, the establishment in Brussels blamed one man above all for the defeat. His name is Declan Ganley. He was one of the driving forces behind the No campaign the last time around, and he’s back to do it again. Your correspondent recently sat down with him to find out what he’s fighting for in trying to see to it that Ireland once again votes No to Lisbon—and in the process, he hopes, forces the EU to choose a different path.

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Ismael Roldan

I put it to Mr. Ganley, an impeccably dressed, balding Irishman of 42, that from Brussels, this whole referendum looks profoundly unjust. Why should 1.5 million Irish voters get the opportunity to hold back the progress of 500 million citizens of Europe?

“I would look at it a very different way,” he shoots back. “It’s profoundly undemocratic to walk all over democracy. . . The Irish people had a vote on the Lisbon Treaty. They voted no. A higher percentage of the electorate voted no than voted for Barack Obama in the United States of America. No one’s suggesting he should run for re-election next month. But—hey, presto!—15 months later we’re being told to vote again on exactly the same treaty.” He taps the table for emphasis: “Not one comma has changed in the document.”

But the insult to democracy is more egregious, in his view, than simply asking the Irish to vote twice—that was already done to Ireland with the Nice Treaty in 2002. In this case, it is not just the Irish whose democratic prerogatives are being trampled, but the French and the Dutch, among others, as well.

In 2005, France and the Netherlands each rejected the proposed EU Constitution in referendums. Lisbon, Mr. Ganley contends, “is the same treaty.” What is the evidence for that? “Well, first of all, the people who drafted the European Constitution say it is. Like [former French President Valéry] Giscard d’Estaing. He called it the same document in a different envelope. And having chaired the presidium that drafted the Constitution, he would know.” There’s more. “He also said in respect of the Lisbon Treaty that public opinion would be led to adopt, without knowing it, policies that we would never dare to present to them directly. All of the earlier proposals for the new Constitution will be in the new text, the Lisbon Treaty, but will be hidden or disguised in some way. That’s what he said. And he’s absolutely right. There is no law that could be made under the European Constitution that cannot be made under the Lisbon Treaty. None.”

So in trying to ram the Lisbon Treaty through, the EU is also undoing the democratic choice of the French and Dutch electorates. “Millions of people in France, a majority, voted No to this European Constitution. In the Netherlands, millions of people did exactly the same thing. When the Irish were asked the same question, they voted no also. Those three times that it was presented to an electorate, the people voted no.” Far from thwarting the will of those hundreds of millions of fellow Europeans, then, the way Mr. Ganley sees it, Ireland has a duty to them to uphold the results of those earlier votes. Approving the treaty would be a betrayal of those in France and the Netherlands—not to mention the millions of others who were never offered a vote on the Constitution or Lisbon.

Mr. Ganley speaks in a low, measured tone, even when, as he occasionally does, he slips into rhetorical bomb-throwing mode. “Why,” he asks, “when the French voted no, the Dutch voted no and the Irish voted no, are we still being force-fed the same formula? You don’t have to scratch your head and wonder about democracy in some intellectualized, distant way and wonder, is there some obscure threat to it.” He adds, without raising his voice, “This is manifest contempt for democracy. It is a democracy-hating act. . . . This is so bold a power grab as to be almost literally unbelievable.”

The nature of the power grab that Mr. Ganley refers to deserves some elaboration. What, exactly, is wrong with the Lisbon Treaty itself? “The treaty is a product and indeed enshrines a set of principles and a way of governing the European Union that clearly shows no will or intent for democracy,” Mr. Ganley says. “You will hear it discussed quietly across the dinner tables in certain sections of Brussels and elsewhere that we’re entering into this post-democratic era, that democracy is not the perfect mechanism or tool with which to deal with the challenges of global this-that-or-the-other. This idea of entering into some form of post-democracy is dangerous. It’s ill-advised. It’s naïve.”

The Lisbon Treaty, like the EU Constitution would have, puts this idea of post-democracy into practice in a number of concrete ways. The most striking is Article 48, universally known by its French nickname, the passerelle clause. It says that “with just intergovernmental agreement, with no need of going back to the citizens anywhere, they can make any change to this constitutional document, adding any new powers, without having to revisit an electorate anywhere,” Mr. Ganley explains. “Do you think they want to revisit an electorate anywhere? Of course they don’t.” If the Irish vote yes, in other words, Oct. 2 would mark the last time that Brussels would ever have to bother giving voters a say on what the EU does and how it does it. Ireland would have, in effect, voted away the last vestige of European direct democracy not just for itself, but for the entire continent.

The passerelle clause is not the only evidence in the treaty of a post-democratic mindset. “The other thing it does,” Mr. Ganley says, “is it creates its own president—the president of the European Council, commonly referred to as the president of the European Union.” This EU president, Mr. Ganley notes, “will represent the European Union on the global stage. This will be one of the two people that Henry Kissiner would call, in answer to his famous question, when I want to speak to Europe, who do I call? He’s now going to have a telephone number, a voice that speaks for Europe, because that voice will have half a billion citizens, legally.”

The other person who would speak for Europe is the “grandly named” High Representative for Foreign and Security Affairs, the EU’s foreign minister, in effect. Mr. Ganley is, as he puts it, “cool with that.” But there is this: “Presumably they’re going to be speaking for me, right, because I’m a citizen,” he says. “But I don’t get to vote for or against these people. So, who mandates them, if not me, as a citizen, or you? Oh, so somebody who is how many places removed from me selects from within one of their own. They never have to debate with a competitor. I’m never given a choice of, do you want Tom, Joe or Anne. I’m presented with my president. Do I walk backward out of the room now?” Just as a yes vote in Ireland would mean that future expansions of the powers of the EU would never have to be put to a popular vote, it would also mean that Europeans would never get the opportunity to elect its highest officials.

It’s easy to see why Mr. Ganley has made himself unpopular in Brussels. And yet, he avows, “I am a committed European. I am not a euroskeptic, not in any way, shape or form. I believe that Europe’s future as united is the only sensible way forward.” It’s just that he fears that Europe, as it is presently constituted, is setting itself up for a fall. “I’m very sure about one thing,” he says. “Which is, if it is not built on a solid foundation of democracy and accountability and transparency in governance, then it will fail. And it’s too valuable a project, and it has cost too much in terms of blood and treasure, to create an environment where this could happen.”

The whole political dynamic in the European Union, he argues, is outmoded. To talk of only euroskeptics and europhiles actually serves the interests of the mandarins in Brussels because it doesn’t allow for the existence of a loyal opposition or constructive dissent. But a loyal opposition is precisely what Mr. Ganley hopes to create. “What I’ve been saying since the beginning of the last Lisbon campaign, it blows fuses in Brussels,” he says. “They just can’t process it. The system crashes. They have to reboot every time because I don’t fit into the euroskeptic box.” Their mentality, he says, is “friend-enemy. Uh, no.” And he points to himself: “Friend—a real friend, because I’m telling you the truth. I’m telling you, you’ve got a problem and we’ve got to fix it.”

He adds, referring to the European establishment in Brussels: “I’ve got news for them. This little European citizen, along with millions of others in France, the Netherlands and Ireland, have now said something to them. And they can either carry on the way that they’re going, and fail, or they can listen to the people, engage them, and bring them along with them.”

Instead of a dense, almost unreadable treaty that shuffles the deck chairs of the Berlaymont building in Brussels, the Commission’s headquarters, Mr. Ganley would like to see a readable, 25-page document that provides for the direct election of an EU president, greater transparency in decision-making and a bigger voice for the people of Europe. “We have to ask more of people,” he says. But equally, “we have to trust people. They talk about the democratic deficit. The deficit of trust is a yawning gap right now in Europe. And the biggest loss of trust has been between those that govern and the people, not the other way around. What was it Bertolt Brecht said? ‘That the people have lost the confidence of their government?’ This is the identical mentality.”

***

Still, for all this talk about democracy and higher principles, the people of Ireland have their own parochial concerns to consider as well. There’s been a lot of talk about how a No vote could hurt the Irish economy in some way. And a number of big multinationals in Ireland have called on the Irish to ratify the treaty and let it go forward. Is Mr. Ganley putting his country at risk by calling for a No vote?

He emphatically denies it. “The only people at risk in the Lisbon Treaty are these elites in Brussels,” he scoffs. “Somebody said last time that Ireland would be the laughing stock of Europe if we voted no. Well, we voted no, and actually these elites in Brussels became the laughing stock of the people of Europe. That’s what I saw in the weeks that came afterwards.” He goes on: “The only people we risk annoying are a bunch of unelected bureaucrats and what I call this tyranny of mediocrity that we have across Europe.” What’s more, he says, “the Irish have never been afraid throughout history of asking the tough questions and standing up for freedom and what was right against much, much bigger opponents. In fact, we seem to revel in it.”

It was easier to revel, however, when Ireland was still enjoying a boom of historic proportions. Will the Irish decide, this time around, that it is safer to keep their heads down, and go along with the program? In Mr. Ganley’s view, this would be totally self-defeating. If Ireland votes Yes, he says, “We’re getting nothing in return except to be patted on the head by some mandarins and told we’re good Europeans. Would we be acting as good Europeans if we said yes to this?” He thinks not. “If this question was asked of the people of Europe, whether they wanted this constitution, we know almost for sure that en masse they would vote no.” And yet, “We’re almost literally being held hostage, with a gun pointed to our head, and being told, if you don’t sign this thing, unspecified bad things will happen. But what they’re asking us to do is to sell out the rest of the people of Europe.”

And the whole European project—which he supports—”has to be about ‘We, the people,’” Mr. Ganley says. “It’s not top-down, it’s got to be bottom-up. And the European Union right now is top-down. It does not have the support of the mass of its people. It does not have their engagement. They don’t even know what’s going on. And it literally conducts its business behind closed doors, and that has to stop and it has to stop now.” If Mr. Ganley has anything to say about it, it will stop in three weeks, in a little country called Ireland on the Atlantic periphery of Europe.

Mr. Carney, the editorial page editor of The Wall Street Journal Europe, is the co-author of “Freedom, Inc.,” due out in October.

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Economics in Crisis

Economics in Crisis

Neville Bennett
July

Ben Bernanke told a town-hall-style meeting in Kansas this week that he was not going to “preside over the second Great Depression”. Dr. Bernanke appears to be fighting to save his job and reaching out to the people for understanding and support.

He told the audience that he had not wanted to prop up the big finance companies: indeed, “nothing made me more frustrated, more angry, than having to intervene” when corporates were “taking wild bets that had forced these companies close to bankruptcy”. Although “disgusted”, Bernanke was minded that “when an elephant falls down, all the grass gets crushed”.

This episode is interesting because it reflects a notable former economics professor confronting the possibility of a depression. It comes at a time when world trade and economic production is tracking the Great Depression. It would have appeared an impossibility even four years ago and economists are reeling, especially people like Paul Krugman are saying a macroeconomics education is “a costly waste of time”. He told an LSE audience that most macro was “spectacularly useless at best, and positively harmful at worst”.

Few Crystal balls

Economists did not see the crisis coming and are somewhat divided on how to treat it. When I studied economics at the LSE, it was widely assumed that crises were a thing of the past. Economic growth could be managed, and any small fluctuation in demand could be easily dealt with by adjustments in monetary and/or fiscal policy. We students thought it was not difficult to plan for growth. Paul Samuelson’s “economics”, our textbook dismissed crashes in a few lines.

But there was a stable environment. Banks were conservative institutions and very reluctant to extend credit. I recall an interview when I was a student, on a good scholarship, where I asked for a loan in order to buy a cheap Vespa scooter( these were much admired in the UK). I was given to understand that the risk was unacceptable. The manager implied that the mighty Midland Bank could come crashing down if I failed to meet my repayments, which I might do if I had an accident. I was in my mid-thirties when all that changed, and credit cards were showered upon me.

The main source of economic instability in my earlier life was foreign exchange. But there were strong management systems. In the UK and NZ foreign transactions were controlled. Tourists had limits on the amount they could spend. A property bubble was inconceivable as mortgages were tightly controlled. Practices were solid, and the theory appeared robust.

Keynes

Classical economists assumed that full employment was usual because supply created its own demand. They thought that income was either spent or saved. Spending stimulated the economy and savings went into investment

The theory did not explain the Great Depression. Keynes explained that uncertainty motivated entrepreneurs and savers alike to stay their hand. Both might develop a liquidity preference. Demand would fall. If private sector activity slowed, the public sector should be involved through low interest rates and public works if necessary.

The theory was avidly adapted in the western world. Keynsian economics worked to get the world out of depression, manage the war effort in the UK and USA without massive inflation, and promote growth though to the 1980’s. But economists were baffled by stag-inflation, and in the US split into two camps.

Freshwater v. Saltwater Schools

The University of Chicago blamed stagflation on central bankers who meddled too much in the economy in order to smooth oscillations. The lake-siders believed in the classical assumption that markets cleared, eventually goods were cleared leaving no inventory or unemployed workers. Their opponents were the coastal universities ( “salt-water school”) who held true to theory that markets could malfunction, justifying state intervention.

The Economist has recently reviewed this debate and said eventually the schools melded into brackish macroeconomics. One product was “inflation targeting’, embraced first by New Zealand, and later by Canada, the UK, Sweden and some emerging countries. Ben Bernanke was a renowned member of brackish economics. From the mid-1980’s until recently it seemed that macroeconomists knew what they were doing. Certainly there was price-stability and that was also the focus of central banks.

Blind spot

Economists and Central Bankers failed to appreciate the risk of financial instability. LSE professor William Buiter now argues that training in macro is a severe handicap. Student worried about the cost of goods and wage rates but did not think of the price of assets. Too much faith had been put in financial markets, and the financial system was under-studied.

In many macroeconomic models, it is assumed that insolvencies cannot occur. It stretches the bounds to credulity to discover that the Bank of England’s model is indifferent to whether business is funded by equity or credit. It does not even incorporate financial intermediaries such as banks. As Buiter observes, the model is useless for issues where financial intermediation is of importance. Pity this crisis is such an issue!

The modelers eventually smooth away many issues because they are too complicated. They find it easier to assume a firm can always borrow as much as it needs at the going rate or sell as much as it desires. This spilled over into financial organizations who made the fatal mistake that they could always sell structured products . but as readers of this column will know, that first casualty of the crisis was “over-the-counter” markets used for selling bundles of sub-prime or similar constructs. There was no exchange for these goods and sellers could not establish a market. Many firms disappeared in a liquidity spiral. It brought back Keynes’s concept of liquidity preference.

The Fed also had models which have not stood up well. In the summer of 2007 it predicted that even if the housing market turned down by 20%, GDP would fall only by 0.25% and there would be negligible unemployment. All the Fed had to do was reduce interest rates by 1%, and the damage would be contained! Fantasy in the Fed!

 

ECONOMICS IN CRISIS 2

NEVILLE BENNETT
AUG 09

On a visit to the London School of Economics in November 2008, H.M. The Queen demanded to know why nobody had anticipated the credit crunch. Predictably the School set up a committee, even co-opting the Bank of England and arch conspirator Goldman Sachs. With lightning speed it replied last week, a mere eight months later.

It blamed “financial wizards” who believed that their plans to protect the financial system were infallible. They were guilty of “.wishful thinking combined with hubris”. This is more charitable than the view put forward in this column recently (NBR 24 July) that the wizards are corrupt. The letter says, moreover, that the crisis was “caused principally by a failure in the collective imagination of many bright people…to understand the risks to the system as a whole”.

As explained last week, this is also the view of Ben Bernanke who is “disgusted” because corporates took “wild bets that forced these companies close to bankruptcy” ( NBR July 21). Nevertheless, at the same time I pointed out that the models used by the Bank of England were absurd in concentrating on price and labour cost movements but having no interest in credit.

Lack of imagination in economics

That brings the discourse focus back to economics, and more discussion of why economists in general have been found wanting. The Economist summed up the charge.. “they helped cause the crisis, that they failed to spot it, and they have no idea how to fix it.”. The charge is comprehensive, and untrue and unfair to all economics and economists, but it appears to have a hard core of substance in the case of macro and financial economics.

The critics have emphasized the flawed assumptions in models. Models assumed market efficiency: a firm could always get credit at the going rate and sell at the going rate. In the crunch the market for derivatives disappeared and many desperate firms could not get credit. Indeed, banks remain reluctant lenders, even to each other, and credit is tight in the US, UK and EU.

I explained last week that the Bank of England model did not include banks, and the Fed assumed away asset bubbles. Both banks focused on price not credit. The Fed also assumed asset booms would be smoothed by efficient markets, but even if they did not, it was more efficient to let them run their course and clean up afterwards. “Efficient markets” doctrine clashed with stopping a bubble forming.

Macroeconomists had imperceptible interests in financial markets. These enjoyed perfect information, competition, and always cleared. Their models assumed an asset would hold its price, even if everyone else was selling. They also though a few years data was enough: it established that house prices never fell and stock markets never lost more than 5%.

They had no interest in fiscal policy because it had few effects, it could be left to others such as political scientists. Paul Krugman says that of the 7000 papers published by the US National Bureau of Economic Research (1985-2000) only five mentioned fiscal policy in the abstract or title. The Bureau is the central clearing-house for macroeconomic research; it also dates recessions.

Nastiness in common rooms

Many economists are uninterested in the real economy, but they are capable of being perturbed when Paul Krugman dismisses their discipline as spectacularly useless and positively harmful. This could affect student numbers and cannot be ignored! Krugman compounds his insults by saying the masters should be re-read, especially Keynes in order to get back to a sound basis. Macro, he says is in a Dark Age having lost the wisdom of the ancients.

Krugman’s Keynesian call for massive spending is not universally supported in common rooms. One issue is the size of the multiplier. Keynesian’s often argue that a dollar spent by government on public works (now called “infrastructure”) resulted in more than a dollar’s worth of stimulus. Economic critics like Professors Lucas and Barro criticize the estimates of Barrack Obama’s economic advisors as absurd, according to the Economist.

Financial Economics

Financial economics is also struggling to restore its reputation. One core doctrine is the efficient market hypothesis (EMH): that the price of a financial asset reflects all available information. It is assumed that if the price was too high, smart investors would make money by shorting it. If it was too low, investors would go long. This was the basis of much hedge fund arbitrage. It was the basis too of many derivatives. The meltdown by Long-Term Capital Management in 1998 made no discernible impact on derivative writers who continued to under-value systemic risk.

Behavioral economists have been critical of financial economics for a long time. They insist that prices can get out of line for a long time, and emphasize that investors get too exuberant in booms and too much given to despair in slumps. But although the EMH is dented, it has yet to be replaced.

History Neglected

I personally feel that the lack of imagination admitted by LSE’s wise men owes a lot to the neglect of history, both of economic history and the history of economic ideas. Like Krugman, I have been re-reading classic writers and have found that crises have attracted much study in the past. I have read some great thinkers on a record of events, like Bagehot on the 1885 crisis and Lionel Robbins and J.K.Galbraith on the Great Depression.

There have been so many crises in the past that boom and slump is obviously inherent in capitalism. I have half-written a book making boom and slump the central part of a new interpretation of NZ history but lack the funds to complete it. I have no doubt there is a need for such history. (Gillian Tett’s “Fools Gold” helps explain the recent crisis)

While history can result in convincing explanation, there is also a need for a theory of crises and explanations of their everlasting occurrence. At another time, I hope to show that ideas from Sismondi (died 1842) Aftalion, Speithoff, Cassel and Schumpeter have relevant insights.

An Updated Take on the Economic Situation

IMF Bombshell

Neville Bennett

There is a disconnect between the real world and Wall Street. Wall Street prices surge while real economy difficulties increase daily. Exports are falling, house prices are declining, and no-one can sell cars. However, There is a perception of “green shoots” indicate that that the real economy may recover quite soon because the financial sector has recovered, and a bull market is underway.

The financial sector, however, has been singled out by the IMF for a thorough review. It emphasizes the key challenge of breaking the downward spiral between the financial system and the economy. The IMF believes that “promising efforts” are under way to redesign the global financial system to provide a more resilient platform for sustained economic growth.

OVERVIEW

The financial sector needs mending. Banks and corporates need refunding, balance sheets have to be bolstered, and capital needs to flow across borders, especially to the merging countries. There is on-going destruction or corruption of assets, and the latest IMF estimate of write-downs has increased from US$ 2.2 trillion in January, to a possible US$4 trillion in April. The increase arises partly because of worsening picture of economic growth and the spread to other mature market-originated assets. About a third of newly-emerging write-downs will be incurred by non-banking institutions

There have been some improvement in interbank markets but funding remains a difficult issue, especially long-term funding. In some jurisdictions banks can issue government guaranteed, longer term debt. But the funding debt is big, with the result that many corporations are unable to obtain bank-supplied longer term debt or even working capital.

Present Risks

The crisis has deleveraged asset prices causing much distress. Some Pension funds and Life Insurers are now underfunded. Some managed their risks prudently, but others undertook risks which they did not really understand. The greatest problem is, however, the decline of cross-border funding. Emerging market economies desperately need refinancing, probably to the tune of $1.8 trillion in 2009. They had relied on private capital flows but these have been reversed.

Although there have been massive fiscal stimulus packages already, further policy action is necessary to restore confidence and thereby relieve uncertainty. Uncertainties are “undermining the prospects for an economic recovery”. The cost of these packages is causing concern, especially when the debt burden combines with longer-term pressures from an aging population. There is a “home-bias” as officials encourage banks to lend locally and consumers to keep their spending domestically orientated.

These are extremely challenging times as officials try to break a downward spiral which is dragging down the financial sector and the real economy.

Recommendations

The economic recovery will be protracted. The deleveraging process is not over and will continue to be slow and painful. Credit growth will contract in the US, UK, and EU, and only recover after a number of years. But political support for more fiscal and monetary aid by the state is waning. There is a risk that governments will be reluctant to allocate sufficient funds to solve the problem.

Restoring the banking system will take several years. Governments should co-ordinate policies to ensure that the banking system has access to liquidity; the impaired assets are identified and dealt with; and weak banks and other viable institutions should be recapitalized. Lessons from previous crises suggest that very forceful measures are required to resolve financial sector weakness.

The IMF has tried to assess existing losses and possible future write-downs in Western banking systems in 2009-2010. Its lowest estimate is $275 bn for US banks, $375 for Euro and $125 for British banks, and about $100 bn for other European banks. But the banks must first increase certainty identifying their capital needs and disclosing impaired assets. Bank supervisors must be very strict in evaluating bank claims and business plans. Viable with insufficient capital could get sufficient capital injections from the state to encourage private capital to join in raising capital ratios.

While banks use public money, their operations must be closely monitored, dividends and restricted, and compensation closely examined. There will be cases to replace top management. Non-viable banks could be merged with others or undergo orderly closure.

The difficulty in attracting private capital means deep government involvement is necessary, even to the extent of taking control. But ideally, the bank will be returned to the private sector as quickly as possible. It would be helpful to convert Government holdings of preferred shares to common stock.

Funding Needs

Bank funding remains highly stressed. Some governments have guaranteed deposits and some forms of bank debt, but wholesale funding is inadequate. Central banks will continue to need to provide ample liquidity for the foreseeable future.

Emerging markets are hemorrhaging capital and this will continue over the “next few years”. Their central banks will also need to provide ample liquidity, and also perhaps foreign currency through swaps or outright sales. IMF’s enhanced resources can buffer the financial crisis. The larger problem in emerging markets is a lack of capital to roll over corporate debt. Government support seems warranted to keep trade flowing and limiting damage to the real economy. The situation warrants devising contingency plans to prepare for large-scale restructurings in case circumstances deteriorate further.

Pressure to support domestic lending may lead to financial protectionism. In several countries authorities have stated that banks receiving support should expand their domestic lending. This could crowd-out foreign lending as banks face on-going pressure to delever balance sheets, sell foreign operations and remove risky overseas assets. These policies can damage the global economy.

Fiscal issues

Credit growth is necessary to sustain economic activity. In countries with fiscal room for maneuver, fiscal stimulus will be welcomed by markets. But markets are showing concern in countries where debt is an issue, and bond yields have increased and currencies weakened.

There is a universal need for stimulus now, but this clashes often with issues of sustainability. Governments risk a loss of confidence in their solvency if there are no plans for debt reduction

Conclusion

Policymakers have to address urgently the present crisis as well as devising a more robust financial system. Improved financial regulation and supervision are key components in preventing future crises by mitigating future systemic risk. The financial system will remain under pressure for years and require massive new funds.