Thursday, October 16, 2008

Bailout, fallout

From Business world Online:
Hold the cheering. The modest upturns — after major crashes — now being reported in global stock markets in response (possibly) to massive govern- ment bailout plans in the US, Germany, the UK, and France do not indicate that the present crisis is over. The sad fact is that the "rescue" packages do not resolve problematic conditions in the US and the networked rest of the world. These conditions still mean a deep US recession and a global economic slowdown that will affect everyone.
To realize why, one needs only to revisit how the US Federal Reserve Board’s easy money policy over the past several years brought the world to the mess it now finds itself. It began with easy credit causing American consumers to go on a home-buying binge, developers to embark on a construction rampage, aggressive Wall Street firms to "securitize" pools of even "subprime" home mortgages and peddle these as low-risk securities, and hitherto conservative savings and commercial banks to ignore their traditional credit standards and take on debt instruments whose risk-return character they did not fully appreciate. It continued with American spending leading to huge US trade deficits, with financial institutions in countries running huge trade surpluses with the US needing places to invest their dollars and parking these in high-yielding subprime mortgage notes insured via credit default swaps, with increased demand for American debt paper fueling an even greater production of the same, and with a steep inflationary spiral in the US. It ended with the housing bubble finally bursting, with real estate prices plunging, with homeowners failing or unwilling to make good on their mortgage payments on reduced-value houses, with insurance companies (like AIG) unable to make good on all their default guarantees, and with a financial tsunami raging through markets that had the sophistication (or was it naiveté?) to embrace exotic credit derivatives.
In effect, over the past several years, the rest of the world funded America’s consumer spending boom by lending America money. This is why banks and investment funds outside America are holding vast amounts of American debt paper and why they are now reeling from seeing these assets turn "toxic" and lose much of their value. The bailout plans supposedly address this problem.
The main elements of those rescue plans involve using public money to take toxic assets off the hands (and books) of private institutions and to inject additional capital to shore up the diminished equity of badly hit banks. What the bailout aims to do, in essence, is hold up prices of overvalued American securities by effectively introducing an artificial price floor. As I argued in my column three weeks ago ("Failure of nerve?") when the American plan was still being discussed in the US Congress, this will not work as expected. Astute investors would see through this and, consequently, would consider a government "rescue" as merely a short-term window for dumping bad assets before the supports collapse and prices drop even further.
In that September 25 column, I further argued that a US government rescue of Wall Street "fat cats" was the wrong thing to do, not only from a moral standpoint but also from a practical problem-solving standpoint. I said that spending an enormous amount of public money to take bad assets off the balance sheets of private financial institutions would simply hold back the equilibrating forces of the market from quickly pushing prices of these securities down to their intrinsic values. I thought that this would therefore only delay the restoration of some measure of certainty — the certainty that prevailing prices are reflecting what other investors actually think certain pieces of paper are worth — to an already frightened market and raise uncertainty to the level that leads to a selling frenzy. As it turns out, this is what has been happening. What compounds the problem is that governments of other countries whose own financial markets have been affected by the American tsunami have decided to throw substantial amounts of their own taxpayers’ money into bailing out private institutions of their own.
In fairness to the architects of these bailouts, their objective seemed merely to provide some temporary respite to allow the prices of overvalued American securities to ultimately stabilize in a less frenzied fashion and provide the institutions holding them the time to somehow make the capital adjustments that will cover the holes in their balance sheets created by the sudden dissipation of significant asset values. Much of the pressure, however, for extensive government action to "stabilize" markets appears to come from politically important financial players, both in the US and other countries, who just want the chance to get out before the market hits bottom and want as much of their losses as possible to be absorbed by taxpayers. No one can reasonably believe the rhetoric of these big moneymen that their concern is about the "system" surviving. Their only concern (I believe) is making sure that they themselves survive this sudden downturn that has caught them "long" on overpriced assets. What quick passage by developed-country governments — over public protests — of these rescue packages demonstrates is that, like moneymen everywhere, fat cats have greater clout with their government than the ordinary taxpayer.
In any event, much as bailouts of fat cats grates against all notions of fair play, this might be tolerable to the taxpayers who will pay for these bailouts if the expenditure of their money will actually fix what’s wrong with the financial system, both in America and in the networked rest of the world. The problem is that these bailouts only delay a real resolution. Markets don’t really turn back up until they have hit true bottoms.
I don’t believe that those bailouts will restore to investors the hoped-for level of confidence in American paper or in American institutions. I think that the confidence that has hitherto caused the rest of the world to channel its collective savings into America — thereby financing for years America’s expanding debt and fueling its housing boom — has already been irreparably damaged, at least for now. This is already evident. Investors all over the world are getting rid of American paper as quickly as they can and seeking refuge in commodities and other assets with more tangible values. Those with large holdings of American dollars must be scrambling for ways to convert these into assets denominated in other currencies. By now, everyone must have concluded that — given America’s persistent and increasing current account deficits — the American dollar must be seen as even weaker than it has been taken to be, and weakening. The US Fed will probably raise interest rates to slow down the momentum to sell dollars but that will also dampen economic activities in the US, aggravating its recession.
Necessarily, the end of easy credit and a drop in American consumption means that firms in countries now supplying the US with goods and services are going to experience serious contractions in demand. Since the US is the world’s biggest importer and consumer, a US recession means significant slowdowns in countries with export-driven economies. Moreover, given the protracted boom period in the US and the price heights reached in its inflationary spiral, this recession is likely to be long and deep.
The fallout will definitely affect us. Not as much as it will affect other countries, though, because we do not have large accumulations of American paper and our economy is not as dependent on our exports to America as others (the US accounts for only about 15 percent of our exports). Also, Filipinos have not been — fortunately, in an ironic sort of way — in any kind of consumer spending bubble, so there is nothing that can burst. Still, we need to brace ourselves. Even the wake of a tsunami can sweep flimsily built structures away.
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