We spend so much time trying to figure out what’s ahead that we forget a simple fact: what’s happening now has its causes in previous actions and decisions.
That is a fancy way of saying that maybe it’s a good time to stop prognosticating and take a look back at the origins of the credit crisis. Instead of guessing what each piece of news means, let’s just look at the facts. Fortunately, the Bank for International Settlements has done it for us!
“The unsustainable has run its course,” is the title of the introduction to the Bank for International Settlements’s 78th annual report. The intro traces some famous historical manias and their inevitable conclusion, including the long recession of 1873, the Great Depression, and the Japanese and Asian crises of the early 1990s. Don’t read it if you’re depressed.
“In each episode,” we are told, “a long period of strong credit growth coincided with an increasingly euphoric upturn in both the real economy and financial markets, followed by an unexpected crisis and extended downturn.” Guess where we are now in the cycle?
One really important point in the Bank for International Settlements’s paper is that what happens at the periphery can happen at the centre too. For example, many people can’t figure out how the collapse of a tiny market (the U.S. subprime market was just a small portion of the total global financial system) could throw the entire system into a state of crisis and self-doubt.
The answer is that the subprime crisis was just one example of a global phenomenon in which the plunging price of money led to an explosion in financial speculation. With the price of money being so low, there was almost no penalty for bad risk taking and failure.
That isn’t that unusual really. If you change the incentives in the financial world by making money free (negative real interest rate) and you combine it with the phenomenon of securitisation, where debt can be packaged up and sold off, then you can see that it was in the financial interests of banks and investment bankers to make as many loans as possible.
It is not in the best interest of an economy to businesses engage in financial speculation instead of real economic activity. That’s why our central bankers are to blame for this crisis. It will be realised eventually.
But for now, it now turns out that the huge expansion in credit and debt instruments didn’t result in new wealth or productive assets at all (except in China). That’s why asset values are falling all around the world, and why many people will come out of the boom poorer than they went to it. But it didn’t always look that way.
At first, as the Bank for International Settlements paper points out, all the supply shocks associated with globalisation were positive. That is, stuff got cheaper while shares and property went higher! Cheap goods started rolling out of the factories in Asia and onto the shelves in Australia and America. With interest rates and energy and retail prices low (ah the Goldilocks Golden year) savings rates declined.
Now, of course, all the supply shocks are negative. Food is up. Fuel is up. The price of money is up, too. The two largest consequences of the easy money period where much lower savings rates (and higher personal debt rates) in Anglo-Saxon economies…and a huge boom in fixed capital investment in China (the fuel for the Aussie resource boom).
To review, Westerners have seen their wages fall, their factories flee, their portfolios plummet, and their houses swoon. China owns a lot of U.S. dollars and a lot of factories that make stuff for people who can’t afford to buy it, while also belching out a lot of smog. The old model has one foot in the grave and the new model is just a twinkle in globalisation’s eye.
Perhaps that is all a bit simplistic. But that’s the current state of play.
Markets and Money