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October 13, 2008

Shedding light on the factors

"Huge current account surpluses built up in Asia and other countries after the 1997-98 financial crisis funded huge US budget and current account deficits ushered in by the election of President George W. Bush in 2000."

Linda Lim, for The Straits Times (Singapore)
10/13/2008

Shedding light on the factors

How did things get so bad so fast? Truth is, the current global financial crisis was a long time coming.

Huge current account surpluses built up in Asia and other countries after the 1997-98 financial crisis funded huge US budget and current account deficits ushered in by the election of President George W. Bush in 2000.

Aided by a Republican Congress until the 2006 mid-term elections, the Bush administration embarked on expensive foreign wars and chalked up large domestic expenditure without requiring Americans to pay for them.

Instead, foreign borrowing allowed taxes to be cut while the Federal Reserve under Mr Alan Greenspan kept interest rates too low for too long, which, added to foreign capital inflows, made cheap money available to all. Not surprisingly, personal savings rate fell to below zero, stocks boomed and an asset bubble developed, most notably in the housing market.

Believing that housing values would not fall, Americans bought more expensive houses. Some invested in multiple properties with borrowed money, a major reason for the excess supply now weighing on the housing market's recovery.

Home equity loans also enabled Americans to borrow against the rising value of their homes for current consumption. Economists call this a 'positive wealth effect'. People spend more as their assets rise in value even if their real incomes stagnate or decline, as they have done for more than 96 per cent of US workers since 2000.

At the same time, a US administration preaching free-market principles while practising fiscal profligacy pursued an agenda of financial (and other) deregulation. This encouraged the 'financial innovation' that gave us sub-prime mortgages, collateralised debt obligations, credit default swaps and other complex instruments, not to mention the amazingly high leverage ratios and risk tolerance that came along with them.

It is this house of cards that has now come crashing down, dragging the whole world economy with it.

Could all this have been predicted? It was - by many, including my University of Michigan colleague, the late Edward Gramlich, a Fed governor from 1997 to 2005. He repeatedly and unsuccessfully tried to persuade Fed chairman Greenspan to crack down on excessive and predatory mortgage lending practices.

But predictable and predicted though it was, the crash, when it came, was precipitated by a coincidence of factors that produced a 'perfect storm'. The debt-fuelled US economic boom caused the current account deficit (the excess of exports over imports) to balloon to nearly 7 per cent of GDP by 2006. This exerted continuous downward pressure on the US dollar and foreign creditors found better outlets for their surplus funds elsewhere - in Europe as well as in emerging markets whose own export-led boom was itself partly the result of insatiable US appetite for imports.

The depreciating dollar and rising commodity prices increased US inflation, requiring the Federal Reserve, as well as other central banks, to accelerate raising interest rates in 2006, even as the US economy was beginning to slow down.

Soaring oil prices in the past two years aggravated nervousness about the economy. Oil-dependent sectors such as auto makers, airlines and tourism were badly hit and began laying off people. And some sub-prime mortgage holders with adjustable rate mortgages found themselves unable to service their mortgages at the higher rates.

While the proportion of such defaulting sub-prime mortgages was small, they had been packaged together with 'regular' mortgages in mortgage-backed securities. Rated as low-risk securities, they had been issued, distributed, insured and held by many blue-chip financial institutions. Greed too often trumped prudence in these largely unregulated private-market transactions.

As the defaults began, uncertainty about the riskiness of individual securities rose. The lack of transparency and the lack of understanding of the securities themselves led to a 're-pricing of risk' and a brutal downward spiral of 'de-leveraging'.

Financial institutions, fearful that they may be holding unacceptably risky assets, began unloading them into increasingly illiquid markets, while 'mark-to-market' accounting rules rapidly eroded balance sheets and capital bases. This forced the afflicted institutions to raise more capital. In the end, capital simply dried up as investors were unwilling to throw good money after bad, not knowing what they were buying.

Thus ensued the current vicious global credit crunch. Banks are no longer willing to lend to each other, due to a lack of trust. If banks cannot get credit from each other, neither can corporations and households. Eventually, various sectors grind to a halt as credit transactions evaporate.

In this environment, the policy actions and inactions of the US government, including its flawed public communications, not only failed to reassure markets, but also injected a further sense of panic. Savings withdrawals and investment redemptions contributed to bank failures and plunging stock prices.

Ideological objections from both the left and right to 'government bailouts' as well as a lack of understanding by a furious electorate on the verge of a momentous presidential election further heightened overall uncertainty. And thus we had a perfect storm.

The writer is professor of strategy, Ross School of Business, University of Michigan.

Posted by zzhu at October 13, 2008 03:40 PM