Opinion: A terrible year

I have been re-reading the great Arnold Toynbee who wrote graphically about 1931: the “annus terribilis“ or terrible year. It seems appropriate this week: the anniversary of the great credit crunch. 1931 saw a record number of untoward weather events, the tragic Napier earthquake, a Japanese attack upon China, and the closure of more than a thousand American banks. Great Britain was driven off the Gold Standard. Its government collapsed and was replaced by the first national (coalition) government in peacetime. The Royal Navy mutinied over pay cuts. Banks crashed in Austria, starting a contagion. 2008 is not as bad as 1931. Nevertheless, The Bank of International Settlements (BIS) says it’s the worst year since 1945. Asset destruction It has seen a massive collapse in asset values, especially CDO’s, buy-out securities, and mortgages. Many finance companies and brokerages have collapsed. Many banks, including such aristocrats as the Swiss banks, Citibank and suave British banks have been humbled. House prices have fallen by 16% in the USA, and prices are beginning to plunge in the UK, Spain, Ireland and New Zealand. Stock markets have crumbled. Finance has grabbed the headlines, but the share price has halved of manufacturers like General Motors and BMW. As well as asset destruction and debt deflation, just like the 1930’s, today's stagflation is reminiscent of the 1970’s. Anyone interested in investing or asset allocation will be keenly interested in whether debt deflation or stagflation will win out. At the moment, both trends are running simultaneously. Counties like Australia, New Zealand, the USA and UK have been living in a fool’s paradise of rapidly rising indebtedness. But it is not just English speakers: Iceland, Turkey, the Balkans and Baltic have massive current account deficits too. Household debt in Australia has reached 177% of GDP, almost a world record (it is 98% in the USA, and 160% of nominal income in NZ). Commodity boom and share bust A commodity "super cycle" has been in place since 2001. This seems to be a response to loose monetary policy and has an inverse correlation with shares. The cycle was also present 1933-51 and 1968-1980/82. According to Longview Economics, the first bull market in commodities resulted in a cumulative rise of 689%, the second a rise of 215%, and the present one 129%, so far. The counterpart of these structural commodity bull markets is a bear market in shares. Equities delivered a flat return for 1896-1920, as they did in the commodity bull market of 1932-1951. Equities halved during the 1968-1980 commodity bull market. The S&P500 has now been flat for 10 years. The current dominant global financial force is debt deflation, eerily akin to the 1930’s. Then, as now, there had been a massive increase of speculation and debt in the previous decade. The current de-leveraging of the debt mountain, and the housing bubble, makes a 1930’s review quite relevant. There are also increases in unemployment. One straw in the wind is California State's recent sacking 20,000 employees and putting 200,000 on the minimum wage. The regulators response Given signs of recession, central banks (except for the ECB) seem intent on stimulating demand. This is understandable, but one wonders if it makes sense because the crisis was caused by unrestrained credit creation, asset price inflation and leveraged debt in the first place. Moreover, another problem is excess demand for commodities at a time of a slackening but massive global boom. If the global economy gets even more stimulus, the result will be higher commodity prices and perhaps a huge crash. Given the experience of high-inflation of the 1970’s, it is surprising that the authorities should keep pushing demand up. The US has rushed through tax cuts, slashed interest rates and bailed out many institutions. It appears to be bailing out householders who cannot meet their mortgage obligations. More stimuli will increase commodity prices, especially food and energy. This behavior is increasing inflation expectations and wage pressures will inevitably follow. Some clarity in this contradictory situation comes from the Bank of International Settlements. Its annual report says the current market turmoil is without precedent in the postwar period. It acknowledges the risk of recession in the US and sharply rising inflation in other countries. It believes the global economy is at a tipping point. The BIS blames the crisis on poor quality loans being sold to the gullible and greedy. It is mystified how this shadow banking system was allowed to continue. It is surprising how widely distributed the securitized loans were, and their presence still blights markets. The risks are enormous because the world economy is poised between deflationary financial and house price collapses in some high income countries, and an inflationary commodity boom. There are chronic uncertainties. Is the commodity boom a bubble? Will households curb consumption? How much bad debt is still to emerge? Will share markets recover? BIS believes no one knows what lies ahead. The situation is scary. Nevertheless, BIS has policy recommendations. It is hawkish on monetary policy; its bias is “much less accommodating”. Better a sharp global downturn than a big inflationary upsurge. BIS wants each country to assess its own needs, and is content with the bigger emerging countries abandoning exchange rate pegs. The Bank also criticizes the USA, believing the Fed is often in error. It especially suggests, in a passage redolent of the Austrian school, “If asset prices are unrealistically high, they must eventually fall. If savings rates are unrealistically low, they must rise. And if debts cannot be serviced, they must be written off”. Finally BIS examines the lessons that need to be learned. Some instability is inherent in capitalism, but the huge bubbles in equities and houses are not normal. It does not stress the paraphernalia of modern finance, but its cycles and tendency to “excessive credit growth”. Tighter monetary policy is vital, but it also calls for “macroprudential policies” which focus on systemic risk, shocks, and adverse interaction between institutions and markets. BIS does not advocate preventing institutions from crashing; nor eliminating the cycle of boom and bust: one is undesirable and the latter is impossible. The aim is to reduce the frequency and severity of crises. ----------------- *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. For further reading on the web, see the economics blog on www.ft.com and www.bis.org