A long a painful journey

Just how bad is the global economic outlook? The lack of a consensus answer to that question is telling. Normally, the financial institutions that steer the world economy show a degree of agreement. But these are uncertain times. The International Monetary Fund said recently that the credit crunch had cost financial firms a stunning $945bn; the Bank of England slated that estimate as “misleading”. The IMF was confusing credit losses with losses “implied by market prices,” it said. Those market prices were unrealistic, and the losses they pointed to would not materialise, the Bank argued – things were not as grim as they seemed.

Maybe not, but they are grim enough. The Bank argued in its latest Financial Stability Report that there are cheap assets going begging. In its analysis, sub-prime mortgage backed securities with a total par value of about $900bn should be worth about 81 percent of their face value, but in the open market they are trading at about 58 percent of their value. Put the accuracy of this complicated claim to one side and look at what the Bank is doing here. Basically, it's advising market players on their investment strategy, pointing out that sub-prime securities are heavily under priced. Nobody is rushing to cash-in on this apparent investment opportunity, which means either nobody trusts the Bank's analysis, or everyone is still too scared – with burnt fingers still smoking, they won't touch these assets with a bargepole.

Either explanation is worrying. The Bank has a good record of calling the market – if its view is disregarded now, that points to a huge loss of credibility. If investors are still reluctant to come back into the market, that suggests they are still keeping their risk appetite at starvation levels.
This is bad news. The Bank predicted in its report that investors would get their confidence back soon and the market would start returning to normal. “While there remain downside risks, the most likely path ahead is that confidence and risk appetite will return gradually in the coming months,” said John Gieve, deputy governor. But the report also warned about what might happen if they don't. If investors do not re-appraise risks and start buying again, there is a moderate risk of the credit crisis leading to a vicious circle of a sharper economic slowdown and further problems for banks, it said.

The fact that the Bank stuck its neck out and called the bottom of the market might help to reassure investors, but it might not. The Bank's argument that sub-prime assets now look cheap is based on one assumption: current prices imply an unprecedented level of mortgage defaults in the US. The Bank reckons that it is unrealistic to believe that such a high level of defaults will materialise. But there's a big difference between unprecedented and impossible. Just because it has never happened before, doesn't mean it won't happen now. Interbank rates are still noticeably high, suggesting banks don't trust each other yet. And two highly critical reports have slammed banks for their woeful risk-management practices. It was the collapse in the value of sub-prime mortgage backed securities that exposed how out of control bank risk-taking was, but these assets only represent a tiny fraction of their overall investments. The question has to be this: what other stupid investments has their sloppy risk-taking exposed them to? Are there still skeletons that a continued downturn will bring out of the cupboard?

Investors could well decide that being unrealistically cautious is the only realistic option in the current climate. Julian Jessop, chief international economist at Capital Economics, made a similar point in a recent note to clients. He went on to argue: “The immediate threat of a full-blown meltdown has indeed been avoided. But for the wider economies, particularly the US and UK, the worst is still to come.”

The US is making far more pessimistic sounds than its UK counterpart. After cutting interest rates to two percent, it warned about falling consumer spending, stressed financial markets, tight credit conditions and a worsening situation in the housing market. The Fed's view is that it has already done a lot to allay these concerns, and that given the time-lag that delays the impact of monetary policy changes, it should not do anything more for a couple of months.

Gloomier still is the International Monetary Fund. It warned in April that the US will grow by only half a percentage point this year and next. It also said US woes were hurting Europe. “Europe has so far been relatively resilient to the US slowdown and the global financial turbulence, but the historical record suggests these will increasingly take their toll,” said Michael Deppler, director of the IMF's European department.
The IMF said that the fallout from the credit crisis would combine with the near-record strength of the euro and soaring food and energy prices to knock -adjusted GDP growth across Europe to 2.6 percent this year from 3.9 percent last year. Growth rates in all the advanced economies are projected to fall well below potential for some time, it said. The countries most exposed were those seeing a cooling of once-hot property markets, particularly the UK and Spain. Politicians in Paris, Berlin will no doubt be thanking those conservative continentals who prefer to rent their homes rather than borrow-to-buy. Also vulnerable are emerging economies — such as eastern European countries — with large current account deficits and high external debt, because they would be “especially vulnerable to shifts in investor confidence.”

To make sense of these myriad risks, observers tend to reach for alphabetic metaphors. They talk about whether a recession will be V or U-shaped: a sharp and deep down and up, or a more prolonged but shallower dip. Or maybe we'll experience a W-wobble, where the US economy bobs up and down for a while, sending out unpredictable waves or ripples that knock other economies off course. A recent report from the Economist Intelligence Unit extends that watery metaphor. “What happens if financial turmoil capsizes the global economy?” it asks. Specifically, how will the credit crunch play out as it spreads beyond finance into the real economy?

The report outlines three alternative views of the future. The first scenario, which it says has a 60 percent likelihood of occurring, is that the US economy dips into recession in 2008, but responds to monetary and fiscal stimulus, rallying in 2009. Other developed economies slow sharply, but avoid outright recession. World trade growth and commodities prices stay high, and major emerging markets suffer only a modest slowdown in activity – this might even be a good thing, for some of them.

The second scenario (30 percent likelihood) is that the US economy ignores the Fed's kick-start efforts and slides into a long and deep recession. This would be a seemingly interminable stretch of sub-par growth, comparable to Japan's “lost decade”.

This would lead to a stall in other developed economies, and through a halt in world trade growth and a sharp correction in commodities prices, a severe slowdown in developing countries, including China and India. There would be a massive, worldwide flight from risk, causing asset values to plunge, banks to collapse, credit to contract and the world economy to stall.

The third scenario (10 percent likelihood) is that the Fed's efforts actually give the US economy such a boost that it starts overheating. To calm everything down, and keep a lid on inflationary pressures, the Fed has to start tightening policy again. A rapid u-turn like that would dent its anti-inflation credentials and make it harder for the Fed to make fine-tuning adjustments to policy in the medium term, which would prolong the current downturn.

The nightmare scenario is clearly option two. While it only has a 30 percent probability of occurring, when the EIU last produced a report on the impact of the credit crunch in August last year, it put the same likelihood on the possibility of the US economy falling into recession, which has since occurred. So start worrying.
The report finds that the US economy is vulnerable to some of the conditions that afflicted Japan in the late 1990s, including the failure of conventional monetary and fiscal policy to stimulate economic recovery. As happened in Japan's downturn, the combination of a prolonged correction in the housing market, and the rebuilding of regulatory capital by banks, risks choking off both demand and supply for loans.

Clearly, recession is part of capitalism; the US endures a recession every 8-10 years. But the slump that is now under way could become the worst in more than half a century, with virtually no growth this year, a sharp contraction in 2009 and another year of falling output in 2010, according to the report. The US could lose as many as 5m jobs by the end of that period, with the unemployment rate jumping to well over eight percent.

That would have serious implications for other economies. Japan is highly vulnerable because it has no room for manoeuvre. Interest rates are still ultra-low, but, with the sickliest public finances in the developed world, Japan has no scope for fiscal loosening, the report notes. A sharp fall in commodity prices, coupled with a strengthening yen and economic stagnation, leave Japan vulnerable to a renewed deflationary shock.

Optimists say that breakneck economic growth in China and India will keep the global economy afloat, but the EIU report is gloomy here, too. The growth express train could run into the buffers, as both economies face pressure from the global slowdown and a build-up of domestic problems. Under the report's nightmare scenario, growth in China and India falls sharply in 2009 and rebounds only modestly in 2010. The rest of emerging Asia is also severely hit.
If the dampeners were to fall on the developed world economies, that might at least take some of the heat out of commodity prices – but no it won't, says the EIU report. A shallow and short dip would not do much to help. But a more marked and prolonged decline that included the major emerging markets would kick the floor out from under commodities – knocking down prices too far. The oil price could drop towards $50 a barrel in 2009-10, creating problems for oil producing countries with vulnerable fiscal positions, such as Nigeria, Venezuela, Syria and Iran.
The economic carnage would have another effect, which many would not welcome. Economic and financial policy wonks – who did so little to foresee and fend off the current crisis – would feel the need to “help out”. If the global economy slumps, continued balance-sheet stresses and the threat of further financial failures would encourage policy makers to become more interventionist. Tougher regulation would limit the ability of the financial sector to “innovate” its way out of the crisis. But financial innovation is what got many of them into this problem in the first place.

There is another reason why the global economy will be so hard to fix. When the US Federal Reserve rescued Bear Stearns, the investment bank, in March it elevated the sub-prime mortgage meltdown to historic levels, alongside the 1987 Black Monday stock-market crash, the 1992 attack on the British pound, Mexico's 1994 “tequila” crisis and 1997-8's triple whammy of Thailand's currency devaluation, Russia's debt default and the collapse of an iconic US hedge fund. Serious indeed. But as the economist Wolfgang Munchau argued recently, the problem is not that we face a credit crisis, or a banking crisis. It is wider. There is a property crisis, a food crisis and a commodity crisis, too. The world economy has reached a turning point. The markets might be recovering from the credit crunch, but that is just the beginning.

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