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This time it's different, even though it isn't

"Unprecedented" is fast becoming the adjective of choice when it comes to the current financial farce. No less august reputations than Paul Volker, Forbes magazine and the World Bank have been amongst those making such definitive pronouncements.

Yet any reading of financial history shows that the current mess has fallen neatly into the same stylised template as all the others. So with apologies in advance to the memory of the great Charles Kindleberger, here are the four conditions which seem to be common to bubble formation:

1. Inappropriately accomodative monetary policy.  The gold rush of 1849-1856 leading to crash of 1857, reparations from the Franco-Prussian War in the early 1870s causing the German crisis of 1873; the Fed inflating in 1927 for international reasons leading to 1929; Japan easing to offsett the yeb appreciation in late 80s leading to the Nikkei crash of 1989, Greenspan cutting rates during the Asian crisis of 1997 leading to the tech bust of 2001;
2. Industrial innovation involving some new "change the world" type of technology. Canals in late 18th century UK, railroads during various 19th century manias in the US, autos and radio in the 20s, internet in the 90s.
   
3. Endogenous financial innovation. The joint stock company during the South Sea Bubble, Trust companies in the run up to 1907, Investment Trusts in the run up to 1929;
   
4. Change in regulations US Banking Acts of 1863/1864 for the panic of 1873, Federal Reserve act 1913 leading to the Florida Land bubble of 1924 and arguably even the crash of 1929.
   

Actually, you don't need all four of these ingredients. For example, during this episode we've had no world-changing industrial innovation. But the more we have, the more likely we are to bubble up and we certainly had three of the above. The overly accomodative monetary policy, according to no less an authority than Anna Schwarz occured when central banks world wide (not just the Fed) were very slow to remove the "precautionary" monetary stimulus left in place during the deflation scare of 2002 (we are reassured the same thing won't happen again this time). We had the compounding effect of endogenous financial innovation in the form of hedge funds and the CDS market. And we had arguably the origins of it all in changes in the regulatory regime, one of which was the removal of the 12x leverage ceiling on broker dealers allowing them instead to leverage 30x or even 40x.  

So unprecedented this crisis is not. But is its magnitude unprecedented? I doubt very much if this compares to what the Asian economies had to deal with during their crisis of 1997, where entire nations went bust pretty much over night and the IMF provided the lender of last resort facility only on the condition that recipient countries tightening monetary and fiscal policy. 

Is its magnitude unprecedented in developed economies? I don't think so. What about the Scandinavian real estate/banking collapses in the early 90s? They then, like us today, had a cataclysmic property market collapse which bust the banks, forced massive private sector deleveraging (the bad assets were effectively nationalised in a "bad bank") and decimated aggregate demand. And they then, like us today, were working in a global economy which was completely flat (the Japanese bubble had just burst, the US was living with the after effects of the S&L crisis while Europe was struggling to deal with the high Bundesbank interest rates required by reunification, which would eventually lead to the ERM crisis.)

So ugly as it is (and as a prop trader who's just found himself unwittingly sitting on a land mine I appreciate that this fiasco isn't much fun as well as anyone), I don't think this crisis is inprecedented in form or magnitude. Why do I care? Because the more I think about it the more it seems to me that "unprecedented crisis" is the bear market brother of "this time it's different" which we're all rightly taught to be deeply suspicious of. So I just wonder to what extent it really is ... 

... and then I realise. What I think isn't relevant. None of the above is relevant. Because perception is reality, and the perception among policymakers is that this is all unprecedented. Which means that the stimulus we're now seeing and are about to see in response is also unprecedented. That is very real, and that's what will count ...     

   

Reflating the ponzi

Well, thanks to what appears to be the biggest scam in the history of mankind I currently have more time on my hands than is strictly economic. Every cloud has a silver lining though and on what the BBC say is the gloomiest day of the year with most workers returning to the trenches after the festivities, and with an absence of anything better to do, To Believe is to See is back ... 

At the weekend there was a conference held by the San Fransisco Fed at which the economy experts who not so long ago scoffed at the idea that the current slump might turn out this badly agreed on the need for "unprecedented" stimulus to ward off what, e.g. former governor Mishkin called an "unprecedented" crisis. Interestingly, bleating along with the rest of the herd was Chicago Fed president Charles Evans who as recently as October 2008 was publicly fretting about inflation expectations becoming embedded in the economy. With monetary policy already in completely unchartered waters their call is now for similarly aggressive fiscal policy. 

Why? Because we're all slaves to a defunkt economist of our choosing. In the absence of such stimulus, we are earnestly assured, the economy will do what the US economy did after the Crash of 1929, or what the Japanese economy did after it's crash of 1989. How do we know this?Because that's what the theoretical models tell us and what history demonstrates. Only an idiot wouldn't see something so obvious. 

That the same body of theory at best failed to anticipate the current mess and at worst caused it isn't something too many people seem to be dwelling on. Neither is the possibility that that we may have learned the wrong lessons from our two illustrative episodes of choice. The truth is that the US in the 30s and Japan in the 90s aren't the only examples of post-crash economies we might be able to learn lessons from. Off the top of my head, the UK in the early 90s, all of the Scandinavian economies in the early 90s and the Asian economies in the late 90s suffered extreme macroeconomic post-bubble distress without suffering the "lost decade" currently being peddled as the inexorable trajectory we'll be on without such measures. 

Indeed, the Asian economies recovered pretty smartly from a crisis far worse than the current one despite the IMF imposing the harsh stabilisation policies of fiscal and monetary constraint in the name of restoring credibility - incidentally, the very same policies which supposedly caused the Great Depression. I bet we end up overstimulating. 

 

Slowing the pace of the blogs ...

This was supposed to be a way to help me organise my thinking about what was going on, but it started getting a bit too big and lengthy. And also distracting. So I'm still going to write stuff, but not every day.

The illusion of control, shattered

Since Western central banks of problematically high inflation countries, beginning with the Fed and the BoE, wrang the inflation which had built up over the 1970s from their systems in the early 1980s, there has been a belief that they were somehow in control of our economic destiny. There were a certain set of plausible economic scenarios which "would never be allowed to happen." 

After the 1987 stock market crash there were widespread fears of a return to the 1930s style depression. Greenspan slashed interest rates and injected liquidity into the system. It worked like a dream. Not only was the anticipated economic collapse averted, the market closed the year in positive territory. The tone for the next twenty years had been set. 

By the time of the Asian crisis culminating in the collapse of LTCM in 1998, the tried and tested remedy to any economic problem had become simple - slash rates. Again, it worked like a dream as stock markets and economies not only recovered, they bubbled. When those bubbles burst widespread interest rate cuts becan in 2001 cushioned the fallout. The world marvelled at how shallow the recession had been in the face of significant post-tech-bubble headwinds, and birth was give to the housing bubble. 

But this bubble was different. It was the bubble of last resort and the fallout has been larger than anyone foresaw. And now we've had bank bailouts, insurance bail outs, mortgage nationalisations, TARP relief programs ...  even coordinated rate cuts. Yet the desired effect has been missing. Market falls have turned into market freefalls since the coordinated central bank action because it feels that despite having used up our ammo the monster is still stalking us.

A few days ago I wrote:

"It feels that the only thing preventing all out collapse at the moment is the prospect of some sort rate cut. Soon even that prospect will be exhausted and one feels there will then be nothing holding up the market."

Maybe the 1987 crash wouldn't have led to an economic collapse afterall. The stock market rose because it was going to rise not because Greenspan cut rates. And in 1998, when LTCM bust, the economy did OK because the economy was OK, not because Greenspan cut rates. But it didn't matter. The perception was that central banks and policy makers more generally were in control. Risk assets were peceived to be butressed by different versions of the "Greenspan put" and perception is reality. 

But whereas the inflation scare caused by sharp recent rises in food and energy prices hinted at the underlying truth, the finanancial implosion of the last few weeks has made it obvious. The perception has now been terrifyingly altered. Central banks aren't in control afterall.

How to thaw the mkts ... Ben signals rate cuts .... Fed tries to unblock the CP market ... who will finance the deficit? ... OPEC to cut

During his speech last night, Ben Bernanke was cystal clear - the Fed are ready to cut rates. The stock market rallied all of thirty seconds before beginning its decline on the way to a 5% down move. Asian stock markets are down a similar magnitude, and I suspect Europe will be down more still. The dollar is flat while commodities are mixed. Energy is lower, metals (especially gold up 1%)  and grains are slightly higher ...

... Bernanke might be criticised for yielding one of his most potent weapons against the market - the element of surprise. But this would be very harsh indeed. The market is going to go where it's going to go. It feels that the only thing preventing all out collapse at the moment is the prospect of some sort rate cut. Soon even that prospect will be exhausted and one feels there will then be nothing holding up the market. 

Every policy responce has so far been sold heavily. Yesterday the Fed announced measures to unblock the CP markets by setting up an SPV with Treasury money to buy 3-month unsecured and asset backed CP directly from issuers.  The Treasury will make a special deposit at the Fed to support the facility, and the Fed will lend to SPV at the Fed Funds rate making it neutral to monetary policy. 

This is a crucial intervention as non-financial and blue chip issuers (like AT&T, Boeing and Deere) and even states like California and Massechusetts had recently been locked out of anything beyond overnight liquidity. After LEH went down and ... forget its name - money market fund ... broke the buck, there has been a collapse in demand for any short term money which isn't issued by the government by the money market funds. These states and companies rely on this liquidity to make payroll and pay suppliers. Moreover, the freeze is hurting financial institutions, not only because financials are the biggest issuers, but because the companies are now drawing on credit lines in the absence of any alternative. These had often been agreed years ago when spreads were in single digit bps and used as a loss leader to get advisory business ... seems  like a long time ago now ... anyway, the effect in the credit markets looked good. GE CP spreads came in around 100bps on the announcement. Yet the stock market, after a sharp 3% move higher, soon fell back and began its long descent lower throughout the day. 

Its kinda funny though ... some commentators, mostly those with a more libertarian leaning have suggested that rate cuts are the last thing develped market economies need right now, as though it's  "like giving a junkie another shot of heroin". Since low interest rates caused the mess we're in why are we looking to low interest rates to get us out of it? I wonder what those people will say now that the Treasury has got the Fed to run a SIV to buy commercial paper?! 

Will it work? Once again, it is a step in the right direction. But what's going to happen if the credit markets are still frozen when longer maturity debt falls due, impairing the ability of the companies to fund themselves at economic rates? 

This is how to unfreeze the credit markets - create a centralised exchange for interbank lending. It looks as though we're moving in that direction in the CDS derivatives market already - why not do the same for interbank lending? If I buy an SPX future on the CME or a copper future on the LME, I don't care who took the other side of my trade. The only counterparty risk I have is with the exchange which effectively insures me against counterparty default by charging me a fee which I pay for with membership of the exchange. There should be a similar mechanism in place initially provided for by the governments, for interbank loans. Effectively, the fear of counterparty default would be removed and banks would once again be in a position to lend to one another. 

On March 6th, 1933 facing the prospect of a run on the banking system and on the country's gold reserves, Roosevelt declared a bank holiday to commence four days. In those days Congress hurriedly passed the Emergency Banking Act (By March 9th Henry B. Steagall, Chairman of the Committee on Banking and Currency, apparently had the only copy of the bill in the House. Waving the copy over his head, he entered the House chamber reportedly shouting, “Here’s the bill. Let’s pass it!" They did so in 40mins and a few hours later the House approved it.) Among other things, the Act allowed the RTC to take equity stakes in private sector banks and set up the FDIC deposit insurance scheme. I say we do the same thing right now - we all get a week to recover, the policy makers get a week to set up a centralised clearing exchange for interbank lending and recapitalise our banks.    

Central banks should also be cutting rates though and at long last it now looks as though they're finally about to. So far, the unconventional measures don't appear to have meaningfully narrowed any risk spreads. Rate cuts won't either but at least they'd lower the ultimate cost of capital for those able to get finance. All this delay has felt like we've been watching the house burn down but are scared to turn the hose because we're worried about the water bill ... better late than never I guess, but there isn't much of a house left ... 

But here's another problem - who the hell is going to finance the US current account deficit? The cash-rich surplus economies currently doing the financing aren't looking to clever at the moment and any sudden withdrawal of capital by them could introduce another black swan in a sky filled with them.

For example, illustration of the confusion over the seriousness of the situation in the Chinese real estate markt was provided by Morgan Stanley. One of their economists - Mr. Wang - predicted that "A substantial improvement in the inflation outlook should help ease the lingering concerns about the inflationary consequences of an expansionary macroeconomic policy,'' and that he " ... expects a decisive policy shift toward boosting growth in the coming weeks and months." All sounds sensible enough. Except that the main risk to his forecast was a "meltdown'' in the property sector across the country which "would lead to a massive collapse in real-estate investment". Wang said the consequences of this could be so serious as too offset any pro-growth policies the authorities might attempt, but put such a probability at a comforting 25%. 

Last month, Jerry Lou, one of their strategist said the likelihood of a meltdown was high. Annecdotally, white elephants can be found all over China - empty hotels, shopping malls and sports facilities. And those white elephants are collateral on banks balance sheets somewhere. Also, its nearly always wrong to trust an economist's view, especially if he's a good one. So I'm even more worried that Mr Jerry Lou might be right. If he is, the Chinese will join the Koreans who are already repatriating their dollar holdings to shore up domestic liquidity shortages  ... 

Meanwhile, Russian President Dmitry Medvedev pledged $36 billion of loans to the country's banks for five years to help unfreeze credit markets. That takes the total Russian lending to banks and companies via loans, cash auctions and tax cuts to $190bn in an effort to maintain a decade-long economic boom.  And just in case a quick glance at the stock market didn't tell you how bad things were (down 65% since late May) Russia's big four oil companies have asked the government for loans to refinance debt. Gazprom, Lukoil, Rosneft and TNK-BP are all struggling to raise liquidity at economic rates and so are tapping government reserves ... 

... and in the UAE, the central bank also injected $16bn dollars into their banking system to relieve liquidity shortages there. Nevertheless, Dubai plans to build a 350 billion dirham ($95 billion) development, Jumeirah Gardens, that will be home to up to 60,000 people. It will include offices, retail, residential buildings, two hotels as well as a high-end shopping area andis expected to be complete by the fourth quarter of 2013. Apparently, they think the real estate boom has nothing to do with the recently high but now falling oil price, even though the UAE were shut out of credit markets in 1999 ... if it wasn't so tragic it'd be funny ... 

Speaking of oil ... have the Saudis already pulled back in the 500k bpd they they sold into the mkt after oil hit $147? OPEC members pumped an average 32.19 million barrels a day last month, down 425,000 barrels a day from August, according to the survey of oil companies, producers and analysts. As Goldmans back away from their uber bullish forecast, now saying a rise to $120 was unlikely any time soon, Libya called for OPEC production cuts. The president of OPEC Chakib Khelil said the group would take "appropriate measures" to stabilise markets ... bring back the evil speculators maybe?  

RBA cuts rates by 1% ... events are moving too quickly ... we're watching a policy mistake

A stabilisation of sorts this morning. Asia is still largely softer although there are pockets of green - Korea, Taiwan and Australia are all higher by a percent or so after the RBA surprised the market with a surprise one percent cut, from 7% to 6%. 

There has been the hope of a coordinated cut in recent days ... rate cuts are now the only conventional weapon left in central banks armoury and a globally coordinated move would likely give more bang than individual stand-alones. Who knows if such a move would stave of economic collapse, and God help us if it doesn't - but now is surely the time to try. 

Nevertheless, the BoJ this morning opted to keep rates on hold saying only that economic growth was "sluggish" and likely to persist "for some time given the slowdown in overseas economies is becoming clearer ..." 

You can't help feeling that the world economy is changing more rapidly than its participants can fathom. With his company's stock down 18% yesterday after indicating it stood ready to cut steel production by 15% if needed, Lakshmi Mittal said:

"I believe this situation is short-lived, all of us hope it is short-lived. When this situation is behind us, things will improve.'' 

Only a few months ago the same Lakshmi Mittal said: 

“I can say with considerable certainty that the volatile years of boom and bust are now relegated to the past."  

More serious is that policy makers haven't quite woken up to the problem and the mistakes are compounded an already dire ennvironment as they have every financial crisis in history. In 1930s America it was protectionism, overly tight monetary policy and higher taxes. In Japan in the 1990s it was overly tight monetary policy, bungling financial reform and eventually, higher taxes. 

Today, we have a situation where market interest rates are tightening significantly. Monetary conditions are considerably more restrictive than this time last year, or than this time last quarter, or even at this time last week and the economy is deteriorating lockstep. Yet yesterday, Mr Evans at the Federal Reserve said:

" ... the inflation outlook remains a risk ... energy and commodity prices are notoriously volatile, and could rise again. More importantly, there is the risk that persistently high rates of overall inflation will boost the long-run inflation expectations of businesses and households, and thus become embedded in their actual price and wage setting behavior."

I'm going to put my neck out here, but I think Mr. Evans just might be wrong. The world is already unrecognisable to that which existed two months ago. It is a credit desert and like it or not, economies require the free flowing of credit to function properly. The complete siezure of credit will completly halt economic activity and it is no longer sensationalist to point to the increasingly real risk of depression, especially with central bank attitudes like this. By allowing monetary conditions to tighten so extremely without even trying to lower policy rates we are seeing a policy mistake and history clearly shows policy mistakes make bad situations worse.

Speaking as someone who is structurally bullish of energy, it's difficult to see a doubling of prices while we're looking at a potential debt deflation. This already savage and distressed world-wide financial deleveraging is accelerating and spreading from the US to the rest of the world. Unchecked, the end game is a broken international trading system, an increasingly traumatised world labour force and a radically altered political climate in which international relations will be more strained than they have been since the end of the Cold War. This is the future. Yet policy makers are still looking backwards. 

There is a chance of oil prices doubling in the next twelve months, as there is a chance that a piano falls through the roof of my house, through the office ceiling and lands on my head. There is a much higher chance that this time next year there will be street demonstrations demanding jobs and an increasingly vocal xenophobic nationalism growing in developed and emerging economies alike. Politicians rarely cover themselves in glory in such times.

But few things are as dangerous as a bad idea which is popular. From the Great Deprssion in the 1930s to the lost decade in Japan's 1990s, policy mistakes have been absolutely key ingredients in making bad situations worse. The current obsession with moral hazard and second round price effects echo's, albeit less extremely, the prevailing attitude in the 1930s when Treasury Secretary Andrew Mellon confidently advised Herbert Hoover in 1931:  

"Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down... enterprising people will pick up the wrecks from less competent people."