Friday, 28 November 2008

EU stimulus package – for real?

According to many American pundits, the EU countries are late out of the starting blocks in terms of economic stimulus to counteract the economic downturn. Europe is – so the story goes – unable to agree and to act because of the decision structure of the EU itself.

The EU commission this week released the news that EU will introduce a package worth some €200bn aimed at stimulating the economic activity and that at least made it seem as if something is moving in Europe. Unfortunately, the design of the package will confirm the worst prejudices held by the Americans.

Presented as a major new initative, the EU stimulus package amounts to some 1.5% of the area's total GDP. In terms of stimulus to a world facing a rapidly contracting demand, it is underwhelming. But at least it comes on top of what the individual member states have already put into place or agreed to? Here's the catch: EU's stimulus package contains no new initiatives. It is simply a listing of the initiatives by the member states, nicely presented. It was even made clear that the package could be smaller if some of the member states decided that they could not afford to live up their own spending targets. In other words, a total hoax, proving that the US is always faster, nimbler, smarter, when it comes to economic decisions.

Think again. We have heard of the TARP of $700bn, then some extra $150bn was introduced for other purposes and last week another rescue program of $800bn was presented. Now those are real numbers instead of the scrawny €200bn ($230bn) the Europeans can come up with. And the money is already being spent.

However plausible this may sound, there are a number of misconceptions to clear away. The US rescue packets are not stimulus programs. They are asset swaps. Uncle Sam doles out some money and receives something in return. Money is given to the banks, and equity stakes are received in return. Or packages of mortgage debt. Or anything really that looks slightly iffy. It may well be that the assets received may end up worthless, but the point is that it is all an exercise in balance sheet manipulation. Various US government institutions, lead by the Fed, are simply boosting their balance sheets, swapping one type of assets for another. Given the quality of the assets received, some losses may be taken, but others (bank shareholdings) may indeed turn profitable with time. There is some symmetry to that. The US banking sector is reducing the balance sheets, so the government is boosting the public sector balance sheets. But for now, these programs do not require immediate financing.

Europeans have not been stingy on this front. The total of European asset swap programs exceeds €1800bn, or at least that is what the governments have committed themselves to as a provisional upper limit. In this respect, it is perfectly sane to say that the Europeans have in fact acted with more punch than the friends stateside. It also appears that the Europeans programmes are more thoroughly thought out. So far, the US rescue effort has been an exercise in changing priorities every two weeks or so. It is the result of the US administration constantly being behind the curve in realising where a fire will break out next. The most recent €800bn package is aimed to help credit card debt, student loans, and car loans. Exactly as many observers had pointed out would be necessary. Those loan types were not considered when the TARP was introduced little more than a month ago. Less friendly observers might be less merciful and claim that the rescue action has been run in a totally headless manner.

Of course the various asset swap programs may at the end prove costly to the taxpayers and could entail tax increases in the medium term. However, that is not our concerns here. The important thing to understand is that these programmes were designed specifically to keep the financial systems afloat. Trying to get the economies going is a different issue, and it will have to be resolved by increasing demand. And that is what the economic stimulus packages will be about.

Even if stimulus packages always take some time to put in place, and even if the EU package is nothing but a collection of already decided initiatives, put through a word processor and given a nice layout, it is still a sign that the European countries are doing something. As an example, Spain released details of its programme earlier today.

President-elect Obama has already indicated that he wants a stimulus package of $250bn ready for when he takes office on 20 January. His newly appointed economic team is supposedly already working on it. Given the depth of the problems in the US economy, $250bn will not be anywhere enough and there will be more programmes coming on stream. But the fact is that market talk about the Europeans falling behind the curve is simply not true.

Wednesday, 26 November 2008

Some lessons from Economic Theory 101

As the details begin to come in about the various programs worldwide to help the economies going again after the hitting the concrete wall in September and October, it may be worth taking a look at some of the fundamentals.

For beginners, this crisis does not have its root in exotic financial products, difficult to understand and totally intransparent. Those products only allowed an underlying problem to continue for way too long, namely a "debt inflation". By this I mean that too many economic players in several countries had indebted themselves beyond reason. In times of old – two decades ago – the banking system would have stopped them from doing so somewhat earlier. But this time the banking system had invented products that allowed them to believe that the risks were so effectively diversified that the lending could go on forever. We now know it was not true. And we are up that creek, seemingly without a paddle.

We are now facing a debt overhang of alarming proportions. There are a number of ways out. One is known by everybody who has ever owed a little too much money away – you cut back and live within your means until the situation is mended. For entire economies there is another way out, namely inflating until the real value of the debt has been reduced to manageable proportions. And then there is the tough one, defaulting on the debt. Which is a good deal more difficult for a country to handle than for individuals. We will look at the first one here, as that is the one currently being discussed in the market.

The first solution, to cut back on one's standard of living is exactly what we are looking at now. The traditional recipes – usually dished out to Third World Countries by the IMF – consists in a combination of policies that aim to reduce the standard of living of the households and to boost the exports. This will invariably entail a period of slow or negative growth in private consumption while the savings balances are re-established. This time it is not the IMF who to the tune of a chorus of assorted leftist protests imposes strict conditions. It is the developed economies themselves that are reacting against years of excess.

Whereas the US and the UK undoubtedly are leading the pack in terms of household sector indebtedness, there are many other countries who to some degree are suffering under the same problems. And the world is heading into a rapid and deep recession because consumers are beginning to get very scared and are cutting back on the consumption. This situation is then amplified by a seriously handicapped banking system which has stopped lending despite hefty dollops of state subsidies.

Lesson Number One is thus that we have a recession coming on because it is necessary in order to correct a huge debt overhang.

Now everybody is looking to the governments for help to "kickstart" the economies. UK's Chancellor Alistair Darling presented a package yesterday. US Treasury Secretary Paulson began talking about an additional $800bn of public money on top of the $700bn or $950bn already being doled out to the banking sector. In Europe it appears to be more difficult to arrive at some kind of agreement. France's president Sarkozy has been leaning on Germany's Chancellor Merkel for Germany to take the lead in pulling Europe out of the quagmire. The EU Commission has had to limit itself to call on the Member States to do something and has suggested fiddling with the VAT rates. But so far we are months away from really detailed programs (UK being the exception, probably because PM Brown himself is a former Chancellor of the Exchequer and hence as a grasp of the details. Plus an absolute majority in parliament).

Currently, the game is about guessing "how much" will be needed by way of stimulus. The counterquestion could be "in order to obtain what?" Globally , we are in totally uncharted waters. A severe recession is on its way. So do we want to avoid the recession entirely as some of the players in the stock markets appear to believe with their continued optimistic earnings estimates for 2009 and 2010?

I am afraid that it is not possible. The scale of the debt overhang in the US alone is astronomical enough that it will be a while for them to sort out the mess stateside. And given the weight of the US economy worldwide, this alone will work as a drag on the world economy. Then add the other countries where a property boom has helped to undermine savings. Some of the more thoughtful commentators and analysts appear to agree that the US economy alone could shrink by 5-7 percent in order to impose a sufficiently deep reduction in living standards. While this being a piece of back-of-the-envelope calculation, it goes well with other studies over the past five years addressing the possibilities of redressing the international imbalances.

It appears that what we can hope for is to cushion the blow of the recession, keep the banking system afloat and try to learn from past mistakes. But Lesson Number Two is that nothing can be done now to avoid a recession. We can only hope for its effects to be dampened.

Which leads us to the third issue, namely how to spend the gazillions of dollars/euros/yen now about to be handed out. I am afraid that we have to go back to Macroeconomics 101. Again. Even to those who had hoped that Keynes was well and truly dead, one only needs to mention the word liquidity trap in order to explain the situation. It has been popping up more and more frequently in the past three weeks: for all the help granted to the banking sector, nothing has managed to stimulate lending. We are in a situation where further easing of monetary policy will not work. The details are different from what Keynes explained, but the result is the same. Billions will yet be spent on underpinning the financial system, but will have no effect on getting the economy moving again. In order to obtain that, one has to look to the same elements as in the '30s: Demand.

There is no shortage in Europe of suggestions of temporary VAT reductions. In the US the talk is about temporary income tax reductions. But hey, have a look at the consumer, now understanding that he has bought a family home too expensive for his salary, and his job becoming more and more likely to go out the window as the recession progresses. He is unlikely to spend any windfalls from tax relief of one sort or another on consumption. He will use every penny to reduce his debts. This behaviour is fully in line with one of the more deep-seated theories of consumer behaviour, namely the permanent-income hypothesis, developed by one Milton Friedman in the '50s. It briefly states that consumers will base their consumption on what they believe to be their long-term income and save any windfall gains. Such as temporary tax reliefs...

Over the past three decades, it has become more and more Conventional Wisdom that state-run expenditure programmes should be avoided. No more New Deals to mess with the profit incentive structure in a well-functioning capitalist economy. But we do not have a well-functioning economy at this moment in time. A long, ideologically based foray into deregulation caused us to fall off that road. So the Third Lesson we can derive from basic economic theory is that public sector demand probably will be necessary in order to stimulate the economy.

Monday, 24 November 2008

New US economic team sets off global bear market rally

In the afternoon Friday, NY time, rumours began to circulate that President-Elect Barack Obama had reached agreement with the two people who are supposed to take the central economics positions in his new administration. The rumours were almost confirmed by the Obama camp, so not it is considered as a given that the present President of the New York Fed, Timothy Geithner, will be appointed Secretary of the Treasury and former Treasury Secretary Lawrence Summers will be appointed Head of the National Economic Council.

If these appointments are made – and it appears there is no reason really to doubt the veracity of the rumours – it is a very, very different cup of tea from what we have seen over the past 8 years. For a while I pulled the joke on colleagues of asking them the name of the incumbent Secretary of the Treasury under Bush. Most had a tendency to hesitate a moment. Which was of course nothing but an indication of how far down the list of priorities the economy was to be found during the Bush Administration. This had of course been exactly the opposite of what was the case under Clinton, where Robert Rubin and Larry Summers held star status.

But now the economy is back with a vengeance, and Obama has chosen people respected as highly competent in the area. Geithner has made a quiet but very quick career. His first job was with one very influential lobbying organisation, Kissinger and Associates. He then moved on to the US Treasury Department in 1998 and in 1998 he was appointed Undersecretary, despite being a card-carrying republican. He left to join IMF in 2001 and in 2003 he was appointed president of the New York Fed.

Holding the most influential position in the US Federal Reserve system after Chairman Ben Bernanke, he has been deeply involved in virtually every major turn of the present crisis, and has gained respect as a hands on manager with a very strong understanding of the workings of the financial markets.

Geithner represents a very different approach to the markets from that professed by the current Administration (and the current Treasury Secretary). He is known as a strong advocate of an approach that definitely gives a role to government in controlling and setting the rules for the markets, and for creating a well-defined framework for the economy.

Some pundits have doubted his competence in the field of macroeconomics. One could say that for the coming two years or so, there will be enough day-to-day issues to keep Geithner focused. If not, he will have Larry Summers, his former mentor, available as a long-term planner.

Nobody doubts Summers' academic and economic competences, least of all himself. Earning his PhD in Economics at Harvard, he went on to become one of the youngest tenured professors at the same institution. He has a reputation for being a bruiser and a power player, who has alienated many former friends. After leaving the Clinton Administration He was appointed President of Harvard University and forced to leave in 2005 after a string of internal controversies that culminated in a fight over the relative merits of men and women in academics. He was, however, invited to return to Harvard in 2007 as an economics professor.

While being a strong proponent of international trade – and thus not necessarily in line with many Democrat party members, he is nonetheless a strong believer in coherent economic policies and medium term economic strategies (this term was entirely missing from the Republican vocabulary in the past 8 years). In the position of head of the National Economic Council, his role will exactly be to device such policies.

The markets cheered this new team with a strong rally, also helped by the fact that Obama went on the record to state that he will favour an economic stimulus package in order to get the economy kick-started. Summers has been on the record suggesting exactly the same. And with Citigroup on the ropes, the car industry on the verge of bankruptcy and very sign that the economy is going in reverse, there is no doubt that this was exactly what the markets wanted to hear. Friday afternoon saw a strong rally, undoubtedly helped by the squaring of significant short positions.

Nice words alone will not revive the economy. Indeed, given the need for the US household sector to redress its savings balance, a significant stimulus is needed in order to avoid a deep recession. While Obama may be ready to offer such support, it will be months away and the economy could be a good deal worse before help finally arrives.

Friday, 21 November 2008

Another letter combination to memorise: CMBX

The last two sessions in US market have been scary, and maybe even scarier than anything seen over the last month. Dow is now down 20%+ in November, a good deal more than the 16.6% it fell in the horror month of October. It has been financials and most notably Citicorp which has been at the centre of this new meltdown.

So far, each turn in this crisis has been narrowly related to one or the other segment of asset-backed securities. First it was the CDOs containing Sub-Prime loans. Then it became clear that the market for CDSs is totally intransparent and rather dangerous to dabble in for the likes of – yes, AIG. We have the segment of CDOs based on the Alt-A segment of US mortgage loans waiting for us in March and April when large number of loans will have their teaser introductory rates reset to rates two to three times higher. Right now it is yet another letter combination that proves explosive, namely CMBS, or Commercial mortgage-backed securities.

So far it appears that a game plan for the remainder of this banking crisis is that each of the various segments of securitised loans will blow up. Each time the banks will be hit a little bit harder than expected because despite the idea of securitisation – that the banks did not want to carry the credit risk, but only to receive the fees for arranging – the banks have been greedy enough to still hold quite some risk on the books.

CMBS – to any follower of the story of the Sub-Prime CDO's there should not be any big surprises. Mortgage loans issued to commercial property owners or developers with collateral in the underlying property is now coming heavily under strain because the borrowers are beginning to default on loans. The spread of such repackaged loans had maintained a very respectable and almost constant spread over AAA rated issues of around 200 bp throughout the months of September and October. But in the beginning of this week it went badly wrong here as well. According to the spread, known as the CMBX spread, widened from 250bp on Monday to a rather impressive 850bp on Thursday. The trigger was apparently that two of the largest commercial mortgage loans granted to the Westin chain of hotels are nearing defaults.

Looking at it from a distance it does not appear that we should be anywhere near a crisis yet. The market is of about $700bn and is considered one where everyone involved is a professional – no ignorant Sub-prime borrowers around here. The rate of loans transferred to a Special server – the last step before default – doubled from mid-2007 to mid-2008. All the way from 0.5 per cent to 1 per cent. When compared to the expected default rate on certain mortgage loans of 20% it looks like small fry.

However, now the cat is out of the bag and speculators are taking aggressive bets on a collapse in this market segment. Bad news for Citi, who has reported to have an 11% exposure to this market segment. Big C closed 2007 at 29.44 . It ended at $4.71 on Thursday, down 26% from the day before, having lost some 84% of its value in 2008.

Is this the end of C? Probably not given the bailout package, but it may now be the next bank to be nationalised. Even if it does not happen the last two days prove beyond any reasonable doubt that despite the siren calls to buy stocks at the current very "cheap" levels, the uncertainty continues to grow in the real economy.

Tuesday, 18 November 2008

Cheap shares? Don’t hold your breath

Turn on the business TV and you will find out that according to the experts there, shares worldwide are now cheap. One of the things I have noted, is that the enthusiasm for saying that stocks are attractive appears to be inversely proportional to the age of the expert (OK, Warren Buffett is the exception). I suspect the reason more seasoned observers have some problems digging out the enthusiasm is that "this time it is different".

Remember that catchphrase? It was very popular during the internet boom and summarised the pie-in-the-sky arguments why stocks should continue to increase even if valuations were already off the scale. It of course appeared that things were not different. The stock market proved not to be able to walk on air forever.

This time around I believe the use of the TTID is far more justified. We are not just talking about a normal downturn here. We are talking about what increasingly look like deepest and widest economic setback since the '30s. But we are not only looking at a situation where company earnings are falling as the result of a normal economic recession. We are looking at a situation where a lot of the rules are being rewritten and at this moment in time nobody really knows what the outcome will be.

One thing is certain; the financial sector will come out of this crisis with a dramatically reduced scope for actions and with a significantly reduced profitability. Everybody with some insight into the matters has understood that one of the drivers of the folly in the banking sector has been securitisation. Banks have been able to arrange for credits without having to take the risk on their own balance for very long. This disintermediation will in all likelihood be reversed.

Issuance of lowly rated corporate bonds will be significantly reduced because the borrowers will be critical and the rating agencies will be forced to clean up their act, much like the audit companies after the Enron scandal. The banks will thus have to carry more risk, the risk will be controlled far more precisely and the banks' earnings will come down because the underwriting fees will shrink. Add that the banks will be forced to come clear about derivative products created on the basis of the corporate loans (CDS's and CLO's). If the junk bond debacle in the late '80 is anything to go by, it will be at least 10 years before the CDO's and CDS's will again become mainstream. For a while such products will be vilified and regulators will come down hard on financial institutions if they try to get too massively back into that business.

This will in its turn make life much harder for private equity companies, venture capitalists and leveraged buy-out artists as the effect will be to make credit more scarce and more expensive. Over the past 3-4 years many bankers have privately shaken their head at the fact that risk was priced so aggressively. No more so, and we are likely to go to the other extreme for quite a while.

At the end of the day, the changes in the financial sector will end up making it more difficult to continue with the restructuring trend that has been at the root of the increased profitability of many companies. A combination of increased risk aversion, more expensive credit and tighter regulation is a bad cocktail for a return to the quite intensive M&A activities of the past years. This will in itself act as a brake on the future development of profitability.

But it is getting worse. According to a report titled " Preparing for a Slump in Earnings " from McKinsey, between 2004 and 2007, the earnings of S&P 500 companies as a proportion of GDP expanded to around 6 percent, compared with a long-run average of around 3 percent, with the highest increase in the financial and energy sectors.

This growth in earnings was primarily driven by increased sales. According to McKinsey, expansion of margins was not a significant contributor to overall earnings growth. These revenues were fuelled by the expansion of consumer credit. Now take a look at the collapsing property prices, the trouble in the US credit card companies, the fact that despite massive government subsidies, banks are tightening credit standards. Worldwide – and most so in the US – households will be led into a deleveraging of their own balance sheets. That will – as I have repeated before – lead to a period of sub-par growth in demand.

Then there is the banking sector itself. Using US data, we get the extremes of a story that can be told in every western country: from being 7.5% of the S%P 500 in 1990 it rose to a whopping 22.3 per cent in 2006 and currently it is still the biggest sector, standing at 16.0 per cent. This development is of course the immediate result of the strong increase in profitability of the banking sector. Not bad for a sector that in fact creates no value in the form of GDP except for the salaries to the employed. With the changes under way that will lead to lower profitability, it is difficult to see how finance stocks can lead the stock markets upwards.

There are probably those who are significantly better than I when it comes to crystal ball reading. I just observe that a host of parameters influencing the stock market valuation are in a state of flux. Calling a bottom in the stock market under these conditions appear rather ambitious.


Monday, 17 November 2008

G20 marks the end of American dominance

It is very easy to be disappointed at the statement released at the conclusion of the G20 Meeting in Washington in the weekend. Its carefully crafted words made it clear that there is no agreement on a coordinated effort to stave off the global recession. No joint effort even if the most recent data points to the fact that economic growth is falling off a cliff in many countries, and not only in the USA. However, it is also clear that even if there is no coordinated effort, the various countries will do whatever they can in terms of fiscal stimulus.

There was also a pledge not to use protectionist measures in order to protect the respective economies. But that apart the meeting appeared to have focused a lot on the massive regulatory failure that lies behind the current quagmire. In this respect the meeting was very important.
For starters, it was a G20 meeting and not the typical G7/8 meeting. This in itself is an important recognition that the G7, while not irrelevant, is not the right forum for this kind of meetings. While G7 represents about 55% of the world economy, the rest of the world now represents 45% and it is growing much faster than the G7. Some of the countries outside the G7 hold the world’s largest currency reserves, courtesy the US current account deficit.
When the participants of the meeting now begin to talk about a reform of the global financial system, it is simply a recognition that the monopolar world system created after WW2 is now about to be replaced by a multipolar system.

The global economic system of the post-war era, known as the Bretton Woods, had one anchor, namely the USA, whose economic and military might was considered unassailable. This situation has changed dramatically under the Bush Administration. Or at least it has become clear how much it has changed.

USA is now the world’s largest debtor. Its banking system is in ruins. Its manufacturing sector has largely been dismantled and moved to China. The car industry is about to go belly up. So even if the US economy still is a powerhouse of invention, it finds itself in a dramatically reduced position as an international player.

The US military might is still frightening. But the inability to win a resounding victory over insurgents in a smallish Arab country has not been lost on many.
In other words, the rest of the world does not any longer see the USA being able to dictate the conditions for economic and political cooperation. The content of the statement concluding the G20 meeting reflects this fact.

The bulk of the text is about a reform of the international economic system. If all the elements of the text are in fact implemented, the US will have to accept that its financial watchdogs are essentially a part of an international system and must adhere to international standards. US regulators will have to adhere to rules for transparency. Its accounting laws will have to be harmonised. Risk models and risk accounting will be harmonised with the rest of the world.
Its banks will be forced to operate under conditions that will look much like how the rest of the world operates (and become dramatically less profitable).

The sacred right of US CEOs to receive silly amounts of money as remuneration will be subject to a review securing that CEOs cannot enrich themselves by increasing risk for the banking sector.

Credit rating agencies (where the US has had a virtual monopoly) will see their influence and business reduced and controlled). An international clearing institution for certain financial derivatives(CDS’s) will effectively remove them from being controlled by US banks. All banks – including US banks - operating cross border will be subject will be under international supervisory committees.

On top of that, tax havens that contribute to the financial instability will be targeted (read Cayman Islands, the home of most hedge funds of this world).

Most of this is sufficiently technical not to attract the interest of the average audience. And it is absolutely certain that the USA will try by hook or by crook not to let herself be tied into such an international structure as it influences something as important as the US banking sector. There will be rearguard action by the truckload.

Yet, the G20 meeting marked something very important: The end of US financial dominance.

Thursday, 6 November 2008

Good luck to Mr Obama. He will need it

Rarely has a US presidential candidate been as popular abroad as Barack Obama. Probably it has to do with his eminent use of classical rhetoric, and on his repeated use of the word “Change” without being overly specific about what will have to change. It has played into a world, tired of the Bush administration’s arrogance and disdain for other nations’ interests or points of view.
Obama may very well be the person to change American politics. Bush and in particular his vice president Cheney chose to take partisan politics to an extreme, and it has left USA with a dysfunctional political systems, unable to even begin handling he enormous problems facing the country: an “endowment” (pension) system that will be insolvent in a few years, the most expensive health system in world that still offers no coverage to 40m Americans, a crumbling transport and energy infrastructure, an education system in dire need of an overhaul. For the sake of his voters – and all other Americans – let us hope that Obama will have the good luck to make progress in increasing the ability of the political systems to make long-term decisions. Even if they are unpopular in the short term.

But for the rest of us, the changes that Obama will bring is likely to be more a question of form rather than substance.

Once sworn in as US President, Obama will still approach the world with the idea to promote american interests worldwide. At the very basic level, there are a number of parameters that have not changed significantly in the past 50 years. First, USA must prevent strategical alliances on the Eurasian continent from developing into a military threat to US security. Secondly, USA will maintain a strong position towards Middle East oil producers. Oil will not be allowed to fall under the control of hostile regimes, no matter their religious background. Third, America must protect its ability to project force to any location in the world. Fourth, USA must try to gain control over strategic elements of the global food supply. And, yes, even if USA has no significant strategic interests there, any USA administration will continue to prop up Israel.

These elements have been underlying the Bush administration forays into Iraq and Afghanistan. Bush and Cheney chose to stop playing by the rules of an international system of agreements, best symbolised by the UN, once they felt it was in America’s interest to do so.

Barack Obama may lead the US back towards participation in the international system of law, agreements and institutions created in the postwar period by the USA herself. If he chooses that route, there is no doubt that the international reaction will be strong ly positive. But do not be mistaken. America’s main national interests have not changed and will be pursued as vigourously by an Obama administration as by the Bush Administration. Only the form will be different.

On the subjects closer to voters and public opinion, terrorism, climate change, and poverty, Obama will probably be far more flexible towards international cooperation. Provided this does not entail a threat to vital American interests

There is a considerable hope out there that Obama will attack the economic problems besetting USA in a more aggressive way than his predecessor. This amounts to simplifying matters seriously, the situation is so complex that caution is required while at the same time speed is of quite some importance.

The immediate economic challenges for Obama contain: declining wage and asset (home and stock market) values, modifying mortgage debt and preventing foreclosures, fiscal impact of bailouts, introducing financial sector regulation, providing fiscal stimulus and cushioning the middle-class amid recession, high foreign debt burden, lay-offs, and continued tight credit conditions.

Later, when all of these items have been brought under control or resolved, US federal government finances will look disastrous, and he will then have to address that.

Obama is facing a cocktail of economic problems in bad need of being addressed quickly. Unfortunately, many of the problems have no easy solution but will entail sacrifice from many of the people who have just voted Obama into office. So the big question is whether he will be ready to use his newly-won political capital and act decisively now or move cautiously and risk being bogged down by competing demands from within his own party. Doing so could be costly for the US economy for years to come.

I have stated it before, but it bears repeating. USA is in the throes of a rapidly unfolding recession, entirely of her own making. American consumers, hooked on credit, have acted together with an underregulated financial system in creating a real estate bubble now collapsing faster and broader than most believed it possible. The very first priority is to stop the rot (or necrosis) in the financial system –including the credit card companies and the auto financing institutions. Next is to cushion the blow of the imploding property prices. Once this has happened the precipitous fall in economic activity will likely stabilise. But that will not be a sign that the consumer can go back to spending like yesterday. Many American household simply have to reduce debt by whatever means they have. Banks will be restricted in their business activities by new regulation. As a consequence there will be no quick return to the carefree spending of the good old days 15 months ago.

The most likely scenario is still no or negative growth in 2009 followed by an extended period of below-par growth. Given the weight of the US consumer in the global economy, the effects will be visible everywhere.

That the financial markets are particularly optimistic about the short term prospects seem rather misplaced. There are no quick fixes to the current situation. Obama will from 21 January 2009 be faced with an economic situation that may cost him the reelection 4 years later if American consumers do not see a marked improvement in their standards of living. So whoever has been afraid that this is the time for Obama and a Democratic congress to begin “redistributing wealth” can rest assured. It will not be any time soon that Obama will have the luxury of that kind of choices.

To those who find this too negative, there are always the historical facts to resort to: Democratic presidents have in the past 40 years been better for the stock markets than Republican ones. Budget discipline has been better under Democrats than under Republicans. Interest rates have been lower. So for the financial markets things will look up. It will just take some time. While we are waiting, things may deteriorate further.

Monday, 3 November 2008

The Banks Won't Lend

Banks do not lend! At least not enough. Instead they appear to be doing what everybody hoped they would not do after receiving generous government help. They appear to be tightening credit conditions and to be hoarding the cash they have been handed. Over the past week we have seen two administrations, about as difficult as they come, the US and the French, both being very frank. The banks better start lending now, or else!

As if it were not enough that the monumental incompetence of US banks in handling the risks related to mortgage lending has thrown the financial sector worldwide into a crisis, it now appears that banks do not readily use the government grants to lend. Instead they appear to be hoarding the cash.

While it is easy to be populist on this one and condemn the banks for their apparently continuing greed when facing the consequences of their past actions, maybe the situation is indeed indicative of a simple fact: the banks are nowhere near to be out of the woods.

Banks are –despite any number of government subsidies and handouts – enterprises that work to maximise their profits under impression of the risks taken. When free cash is not taken and immediately used to boost profits, there are two possible explanations. One is that the banks still judge it too risky to increase lending significantly. The other is that a long-term view tells that there are better opportunities waiting around the corner.

Let us consider the first option, the perceived risk. Here it should be made clear that the crisis hitting the two opposing sides of the Atlantic are in fact very different in nature. US banks are primarily hit by a deluge of bad debts, and have to cope with enormous write-offs. European banks were to a much smaller extent hit by bad debts, even if some illustrious examples had in fact bought some nicely repackaged toxic debts. In Europe, the banks began to suffer in earnest when the interbank market froze up. In this respect the European banks are less severely hit than their US counterparts. Unfortunately, as the weeks pass, this difference is losing importance as banks worldwide are now setting their sights on the accelerating global downturn. Starting in the US, the world was already moving towards a slowdown when the Subprime loans began to go off like time bombs. It is a completely normal reaction from banks to rein in lending during downturns, and has been seen at the onset of every recession.

Looking at the most recent events on the economics front somehow leaves a clear impression of why banks are in no hurry to increase lending. They are simply afraid of throwing good money after bad money.

Last week saw the harrowing sight of a US Federal Reserve Chairman strongly recommending a senate panel to introduce a strong set of fiscal initiatives in order to boost the economy. In plain words: Even if the US government debt is at a post war high, Congress and President should simply increase government spending and care less about the long term effect of the financing. Bernanke effectively told US lawmakers to do something. This is a radical break with the caution usually characterising central bankers. It could easily be considered a sign that Bernanke is afraid of seeing the credit crunch seriously affect credit card debt, auto loans, commercial property finance (and from our own world, leveraged buyout artists and hedge funds). This message is fully understood by the banks, which on their daily business can follow exactly these sectors of the secondary credit creation. It simply indicates that there are still many, many losses out there to be dealt with and it makes sense not to throw the new money around too quickly. While the European economies are less severely hit than the US economy, today’s EU forecast for economic growth was dramatically lower than the forecast published just a few months ago, and the “risk scenario” was even more negative. European banks are likely to be more cautious going forward.

Of course politicians will posture and threaten. The question is just whether increasing loans now makes financial sense in the medium term.

Which leads us to the next reason for sitting on the cash. There has been absolutely no beating around the bush from politicians on both sides of the pond: the name of the game is consolidation of the banking sector. Hank Paulson has said it, Treasury spokespeople have said it. EU’s finance commissioner Almunia has said it. Governments across the European continent have said it. So the governments are very much ready to support further mergers and take-overs. It is all in line with my stated view that we are working towards a situation where each country are trying to anoint certain banks to come out the winners of this debacle. Participating in this game and coming out on top requires some free cash. It may be as simple as that.

I am not trying to excuse the banks. The recent history has shown the sector from its absolutely worst side. But it does not mean that the banks do not have very good and logical reasons not to spend the government handouts immediately. It is just my impression that the current political logic may tend to overlook such niceties entirely.