Friday, 24 October 2008

The morning after

After weeks of what seemed like useless political bickering over a rescue plan that was wrongly conceived right from the start, the US bank rescue plan finally received an overhaul that made it look like what the Europeans are doing. Not that the Europeans were too quick off the mark, the attempts at agreeing a rescue package being delayed by the necessity to balance broad agreement with national political interests.

In the end reason prevailed – at least in terms of the technicalities of the rescue. The Swedish model – itself strongly inspired by the US bank rescue in the ‘30s - is by and large being implemented world-wide: Governments will take ownership stakes in return for money to the banks, guarantees for depositors are introduced or expanded, dud assets will be taken off the balances and the taxpayers will be able to recover some money once the sector recovers. Incompetent bank management will be pushed out. What is now waiting in the wings is a monumental restructuring of the banking sector where the anointed winners will be allowed to take over the weakest competitors.

This slow and grinding process will quickly be relegated to the finance pages of the newspapers. Sadly, since it is in this process the future of the global financial sector will be shaped, and the balance of financial power between US, Europe, and the rest of the world will be determined.

Meanwhile, signs are multiplying that a global economic slowdown is on its way. Financial journalists and bank analysts have managed to convince themselves that the financial crisis is now leading to an economic downturn.

Quite the contrary: financial institutions began to crack up because an economic downturn was already progressing and that created the financial sector crisis. Excessive use of instruments allegedly devised to spread the risk assured that the crisis hit everywhere. However, tightening credit conditions have obviously accelerated the downturn. Globally, the recent coordinated rate cuts had less to do with the financial crisis than with averting a global recession.

Let us establish a couple of facts: Irrespective of the goings-on in the financial sector, the US economy was heading for a slowdown. Former Fed Chairman Alan Greenspan’s policy of keeping the interest rates as low as possible paired with “innovation” in mortgage finance created an unprecedented boom in house prices and loan-financed consumption. Add that the US federal government has been running a huge deficit in the past years. Even if US corporations have been accumulating capital, the US economy has been a rollercoaster, fuelled by overconsumption. Lest anybody does not believe this, let then have a brief glance at the US trade deficit.

It is a particular feature of the US economic and political system that the enduring problem of loan driven overconsumption has not been addressed for decades. It has undermined the standing of the US in the world, turning the world’s most powerful economy into the world’s biggest debtor. Not even the US of A can on a long term escape the plight of the debtor: Reduce your consumption below your income and begin to pay back.

Anybody who has tried to be in this position knows how painful it is to tighten the belt, reduce consumption and postpone consumption one would otherwise have preferred to enjoy now. Usually one has to be careful comparing economics at an aggregate level with household economics. However, this is one case where the parallel is entirely justified. US consumers as well as the federal government will have to endure a period of bringing the books back in good order.

Rescuing the banks will make this impossible to obtain for the federal government, putting even more onus on the consumers. Households will have to save more and consume less. House prices will fall further; employment will have to increase in the short to medium term. Given the weight of the US private consumption in the global economy, slower growth will influence global growth negatively, even if the savings balance is much healthier elsewhere.

We are not talking disasters, at least not yet. If one is to believe international institutions, global economic growth will slow from 4%+ p.a. to somewhere between 1% and 2%. It will still be uncomfortable, as unemployment will increase and property prices will be heading downwards for some time. But it should be over by the end of 2009 or beginning of 2010. Chances are still that the economic effect of the global bank rescue package also counts as a quite significant stimulus package, and provided that the global financial market resume lending operations, growth will probably resume relatively quickly.

USA is in a situation different from most of the rest of the world. Its savings ratio is sufficiently low that it badly needs repair. It is possible that the next administration will aim at restoring the basic equilibrium in the economy, keeping growth below par for all of the next presidential election period. A ‘30s-like depression is unlikely. But a slow, painful period where mainly the households change their savings patterns, forced by the economic reality. It will probably bear similarity to the downturn in the 1970’s where another behavioural pattern, namely inflationary expectations had to change.

The addiction to debt financed consumption is not as pronounced elsewhere in the world (UK being a possible exception, but with much better public finances). US consumers led the party when finance was plentiful. They will now have to take the lead in the headaches and the cleaning up the morning after the party.

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