Opinion: Fear the "Chernobyl" of a derivatives bust

The global economy is gripped by the mightiest financial convulsion in history. The fundamental feature is price deflation. Prices had reached unsustainable levels, especially in housing, and in shares and some commodities. While inflationary tendencies will persist in some areas, there is mounting evidence that the world is about to experience a deflationary shock as great as in 1930. Will the economy soon bounce back? In promoting a "V"-shaped pattern, investment advisors are telling clients their equity holdings will shortly recover, and they should remain fully invested to catch the bounce. A minority perceives a recession before a "U"-shaped bounce-back. I believe there will not be a bounce back to previous equilibrium levels. The old price levels were simply too high, and are being de-levered to a new, lower equilibrium. The future to me looks "L"-shaped. Markets must construct a new baseline, necessarily lower than that in 2007.

Strong inflationary tendencies remain in the global economy, especially in massive liquidity"“creating activities of central banks. The paradox is that the problem in 2007 was too much money in asset markets, especially housing, and central banks now prescribe more money as the cure. I believe we exaggerate the efficacy of central banks. There is a struggle between inflation and deflation, and a coherent outcome will take time to emerge. The credit crash The contagious effect of the crisis on banks is unprecedented. There were bank crashes in 1930-31 in Europe when the US pulled funding, but there were no bank failures in Britain or, indeed, its extensive empire. The US had thousands of bank failures owing to structural defects exacerbated by Federal Reserve policy. This crisis is advancing rapidly because banks have retained many toxic assets. They are reluctant to lend to other institution because of suspicion and the need to retain money to rebuild their own balance sheets. The dysfunctional nature of the systems is indicated by a cession of inter-bank lending, massive increases in Libor, and large deposits by banks into treasuries. Credit markets are drying up, with many firms with high ratings being unable to source working capital. This will soon lead to workforce reductions and deepening recession. Credit default swaps The unwritten fear is that the credit default swaps (CDS) market will implode. CDS are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds. One party, "the protection buyer", covers his investment in say General Motors bonds by buying protection from a "protection seller". The market is not regulated, and at the moment there are medium-sized hedge funds with hundreds of millions in potential liabilities. Unlike insurance companies they do not have to cover their liabilities with realizable assets. Some hedge funds would have banked a lot of fees, but are not in a position to honour their commitments in the event of a default. Will there be defaults? Undoubtedly. This is a time when even California cannot get sufficient credit to fund its payroll and other commitments. Some counties will have difficulty in servicing the interest payments and redemption of their bonds. I have used American states because they are relatively strong and have specialist monoline insurers. Admittedly, some monoline insurers got into sub-primes and have weakened their asset base. Monolines are the biggest CDS "insurers" and Bear Stearns was a massive counterparty in many trades. The massive CDS bubble is intact.  Should it deflate it will create a storm as devastating as subprimes. Journalists are reluctant to broach this topic, but it is raised here because of some New Zealand connection to this derivatives "Chernobyl". Deflation Deflation already exists in stock markets which have generally fallen by 25% or more since last October. In the US, UK, Ireland, Spain and Australia house prices have been on the skids. Falls have been greatest in the US so far (16%) but greater falls are expected in the UK and New Zealand where houses increased to about 8 times the average salary. Prices will decrease to more sustainable price/salary ratios. Treasury forecasts NZ house prices could fall by 25% gross. Deflation thrives on falling demand arising from credit restrictions, slow economic growth and falling employment. Retailers lower prices to stimulate sales. Paradoxically, this reduces sales further because consumers know the desired item will be cheaper in the future. Many consumers are heading for a financial crunch; it has been very easy to spend as much as $1.12c for every dollar earned because of easy credit combined with the media and society, but especially lenders, encouraging unsustainable spending on the house, car, holiday, boat, new clothes and plenty of entertainment. Lenders encouraged a "because you are worth it" mantra but they will now tighten credit as recessions increase bad debt. The Japanese precedent Japan has been gripped by deflation since its spectacular stock market crash in 1989. In a series of events similar to the euphoric Dow index 2004-2007, the Nikkei 225 index trebled between 1986 and 1989, rising from 12,900 to 38,915. It is now at 12,000, approximately a third of its high, twenty years later. The Nikkei has occasionally staged a 10-20% surge, but it is very vulnerable to shocks. Its decline was accompanied by a tremendous correction in land prices. At the height of the bubble, the land area of The Imperial Palace in Tokyo was equal in value to the whole of California. Japan has undergone a terrible correction to reach present lower values of stock and land. The correction was protracted because so many values and attitudes had to change. Arguably the Government could have been more dynamic. It ended by bailing out banks on a massive scale and loading the Government with massive debt, which is hard to pay off with an ageing population. Japan has hardly shaken off deflation in the last two decades despite a supportive, booming world economy to sell its exports into. Getting out of deflation is not easy. Unfortunately, it needs a massive, protracted stimulus such as war to overcome it. ----------------- *Neville Bennett is a long-time Senior Lecturer in History at the University of Canterbury, where he has taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared.