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Economics Weekly

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End of an era as credit bubble bursts

Tue, Oct 14 2008, 11:31 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Too much debt led to bubbles...
One week after the US congress passed the Troubled Assets Recovery Programme (TARP) that was supposed to be the solution to the credit crisis and just 1 day after the UK agreed to spend upwards of $500bn (SARP - Stability and Restructuring Plan) to protect its financial system and after a global coordinated cut of ½ a percentage point in official interest rates, financial markets saw the worst turmoil in decades. What is going on and why did the plans not work? The truth is no one really knows when or how this crisis is going to end, though end it will. However, this is the latest of many bubbles to have plagued the world economy in the last 10-15 years, did not just develop overnight and will therefore take time to resolve. Hence, one year since the start of the realisation that asset markets – more especially housing and credit markets - were grossly overvalued and so was the value of the securities written on them (on which so many financial firms borrowed heavily), the crisis is intensifying rather than abating, see chart a. And this is despite the measures that have been announced to tackle it. We look at some of the main issues in this briefing.

...as fast global growth was accompanied by low inflation and hence low interest rates…
At the root of the current financial market problems is the huge amount of liquidity that was generated in the period of fast global economic growth from the second half of the 1990s to 2007, and the destructive effect that this had on financial markets. Effectively, it led financial institutions in developed economies (because this was where the liquidity ended up) to take excessive risk with their balance sheets and to adopt business models that were not sustainable once this liquidity stopped expanding or asset prices fell. But in the background also lies the fact that the world economy was becoming increasingly unbalanced over this period. In crude terms, emerging markets in Asia save and the developed economies, especially in North America and the UK, consume, this is illustrated in charts b, c and d.

The way this manifested as the world economy became more integrated, and global trade took off, was in large current account deficits in some developed economies and large current surpluses in some emerging markets. This was especially the case for oil exporters and other commodity producers and the manufacturing exporting economies in Asia. In chart d, this is illustrated by rising holdings of foreign assets in emerging markets, with a falling share for the US and Europe.

…and export surpluses were reinvested in the assets of the economies of the developed countries, helping to create bubbles
These surpluses were then recycled through financial markets and led to the buying of assets in developed countries, which provided them with plentiful amounts of liquidity at very cheap rates, in real and nominal terms. Of course, risk taking was encouraged by policies in the developed economies, which kept regulation light or none existent as new financial products were developed, interest rates were kept too low and fiscal policy too loose. Low inflation, resulting from greater global capacity, made this scenario of low interest rates look sustainable. In the US, interest rates were cut to 1% after the terror attacks in 2001 and were lowered around the world, remaining at very low levels for many years. This encouraged the financial markets to invent new products that gave high returns with seemingly low risk that were then widely distributed - now, spreading the losses around, rather than reducing risk.

Abundant funding at cheap rates led to the kind of balance sheet risk taking by institutions that would have then been unthinkable in another period. So this current crisis is likely to reduce global imbalances, or to at least force them to start to correct, but it is, and will be, a painful and long process see chart d. It means slower economic growth for a number of years and less reliance on consumer spending in the UK and US, for instance. To maintain fast growth rates, the emerging markets will increasingly have to rely on domestic demand - higher consumer spending and government spending, as government in the main Asian emerging markets, in particular, run bigger budget deficits, say to fund infrastructure investment in order to maintain growth.

The crisis was always likely to happen as these sets of circumstances were unsustainable and there was too much debt…
Many financial institutions thought that this abundant liquidity at very cheap rates in wholesale markets was permanent and made long term decisions on this view. But it was always an historical juncture that could not last, in which increased competition in global markets and the addition of capacity from emerging markets gave rise to low inflation. So this was never sustainable and as soon as inflation started to rise - as demand for goods increased as global living standards rose and industrialisation around the world drove commodity prices up - so inflation and hence interest rates started to rise. Resultant increased losses led to a realisation that the risk profile of many assets was simply wrong. In particular, the use of complex derivatives (products to offset risk) grew during this period and so led to even riskier practices. Now that this bubble has burst, the widespread use of these instruments and their opaqueness means that their losses are spread wide and are so great that they are too much for the private sector to handle alone. Hence, this means that the public sector’s balance sheet will have to be used to protect against systemic risk and the collapse of the whole financial system. In short, governments and central banks are stepping in to provide funding that capital markets are not able to given the amount of losses they have accumulated and the consequent need to shrink balance sheets.

What needs to be done to help solve the crisis?
A broad outline of what needs to be done has emerged in the last week or so. In our view, they include: creating a market in asset backed securities (ABS) and collateralised debt obligations (CDOs), through government purchase of these securities to find a market clearing price and to value them so that they can be traded and taken off firms' balance sheets (US TARP); provide capital injections directly into banks' balance sheets so that they can continue to pursue their intermediation role of providing funding to households and businesses; to provide guarantees for their activities, including that of lending to each other; and to offer guarantees to depositors so that they do not take their money out and so cause a run on these banks while other action is being taken to restore confidence (UK SARP).

There are other formidable changes and challenges that remain to be tackled as the crisis has highlighted a number of serious shortcoming and flaws in crisis management arrangements; insolvency arrangements, liquidity management, credit analysis, credit rating agencies, insurance of complex products, liability risk measurement etc. Hence, this is a long term problem that will not result in business as usual anytime soon as the changes required are far reaching and complex. The adjustment of the balance sheets of firms in developed economies caught up in this crisis will take many years.

What about growth?
Unfortunately, cutting interest rates alone will not work to boost the economy, it has been used many times in the past decade and indeed may have helped prolong the excess – it will be, or become, as famously put, like pushing on a piece of string. The reason is partly that developed country households are already hugely in debt, see chart e and do not want to add to it, so cutting interest rates reduces their income and will just push them to save even more so cutting spending further and weakening growth. But more rate cuts are still likely to try and support the real economy. In this context, tax cuts and public spending increases would help to support income growth, but with public finances strained by the bank rescue, this is unlikely. The good news is that the more quickly the bad news comes out, the more likely it is that a balance will be found and the markets will recover. But how long that will take is anybody’s guess.

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Published on  Tue, Oct 14 2008, 11:41 GMT