World chokes on bad spell on Wall
St By David Dapice
The
recent meltdown in global stock markets is the
first truly global financial crisis since the word
"globalization" became widely used. While Latin
America and Asia suffered in the 1990s, this
crisis marks a wider, possibly deeper set of
problems underlining how vulnerable the integrated
world economy has become to failures in one part
of the globe. What began as worry over tremors in
the US mortgage market has become a full-blown
confidence crisis.
The fundamental problem
is that financial innovation in the United States
has outpaced the ability of either private
managers or public officials to monitor what's
going on with the financial industry slicing and
dicing loans to create ever-newer instruments
that
few understood. That complexity has tied the
financial world in knots as it seeks a way out of
the mess.
Broadly speaking, each part
of the US financial system became fee-oriented and
ignored basic rules of fiduciary responsibility.
Mortgage companies originated new home loans -
sub-prime mortgages and others - for a fee and
promptly sold them. Banks
bought, bundled, and
then sliced and diced these mortgages into
different risk classes, selling them to hedge
funds and even central banks.
How risky
was each part? The ratings agencies, paid by the
banks that originated these bundles, looked only
at recent default experience. Since real-estate
values had been rising, any borrower in trouble
could sell the property or refinance, so defaults
were low and the bundles seemed safe enough for
AAA ratings.
The buyers of these mortgage
fragments relied upon the ratings agencies. This
debt was safe, but only until property prices
began to drop. Then the lack of underwriting
standards - not even checking the income declared
in some cases - began to matter.
If the
problem were confined to sub-prime mortgages, it
would be a serious but not overwhelming problem.
However, many adjustable-rate mortgages,
home-equity loans, second mortgages, credit-card
debts, and even "regular" mortgages are also
threatened. As property values fall, many
borrowers find their debt is worth more than the
property. At that point, it often makes sense to
walk away from the property and let the bank
foreclose. One reason for the panic is that nobody
really knows how many millions of foreclosures
there will be, how much these will depress
real-estate values and thus render additional
classes of debt suspect. Some observers expect
that commercial-property and regular bank loans
will also suffer as this process proceeds.
Many banks, confident about the loans,
ended up holding some of the debt they originated
or promised to take back debt if the buyer wanted
to sell. Banks now have less equity capital
relative to their loans, as needed to remain
within financial standards. Until that's repaired,
banks will likely be conservative in making loans.
This problem is not solved by low interest rates,
though they might ease the problem over time. With
inflation at 4% and a weak dollar, it's not clear
if the Federal Reserve can lower interest rates
much below 3% without running risks. As of
Tuesday, the Fed lowered the overnight rate on
interbank lending to 3%, and now has little room
to maneuver.
Each part of the US financial
system became fee-oriented and ignored basic rules
of fiduciary responsibility.
Fiscal policy
in the United States is similarly hobbled. The
Iraq war was "paid for" with tax cuts, following
the neo-conservative wisdom that government
deficits don't matter. Because debt to GDP has
grown so much, the feasible amount of tax cuts is
small, only about 1% of GDP. As housing and stock
prices fall, the net worth of families declines
and consumption drops. Since several trillion
dollars of wealth are likely to evaporate and
consumption is likely to fall by several hundred
billion dollars, there's little faith in the $150
billion fiscal-stimulus package announced by the
Bush administration.
In short, there's an
ongoing massive decrease in both housing and
financial wealth, aggravated by reduced bank
lending, and limited ability of monetary or fiscal
policy to respond. This explains why US markets
are weak and many Americans - and some Wall Street
investment banks - think a recession is already
here.
But what about decoupling? Wasn't
the rise of emerging market economies and growing
trade among them supposed to reduce the world's
reliance on the stressed US consumer? Several
points explain the simultaneous movements in stock
markets: First, many banks around the world bought
these "collateralized mortgage obligations" issued
by US banks. Several European banks have suffered
billions of dollars in losses and may face further
difficulties as other loan losses rise in a soft
economy. This makes them more conservative.
Indeed, the European Central Bank has
actually pumped in more liquidity than the Federal
Reserve into shaky credit markets. As the euro has
strengthened - a logical step as global central
banks diversify out of dollars for reserve
holdings - exports have come under pressure and
imports have grown. Finally, several EU nations
also had overheated real estate that has begun to
cool. Overall, Europe finds it has diminished
prospects for growth.
Japan was already
weak with a negative quarter of gross domestic
product - a broad measure of the economy in 2007.
Most of its growth came from exports, which are
now uncertain. Japanese consumers seem reluctant
to spend, and business investment is muted as
exports slow and population declines.
Australia and Canada had strong currencies
driven by the commodity boom, now looking tired.
They might escape if the "BRIC" story had remained
intact and the large emerging economies of Brazil
Russia, India and China continued to grow.
However, the Chinese and Indian economies face
issues of stock-market and real-estate bubbles,
inflation, social unrest, and too-rapid credit
expansion. They, too, are more fragile, and when
money began to seek safety, they no longer seemed
a safe haven.
Like the sorcerer's
apprentice, we have created things we do not
understand and cannot easily control.
So
where is the world economy now? The optimists say
that the real problem is panic, not reality.
Growth may slow, but is intact. Even if the United
States suffers a recession - and many predict it
will not - the other parts of the world will
continue to grow and by the end of 2008 the worst
should be over with. The pessimists cover a
broader range of outcomes, but believe that the
financial fallout from bad debts could feed upon
itself and become worse. Given the limited ability
of fiscal and monetary policy, they see a much
larger chance of a prolonged slowdown or even
severe recession.
Given the complicated
financial links among nations, it's not just a
question of projecting a modest decline in exports
for fast-growing nations like China. Rather, it's
a matter of understanding how the world's
economies are bound together in various ways and
avoiding a self-fulfilling decline in investment
due to conservative banks and diminished growth
expectations.
A witty economist once said
that stock-market declines had predicted nine of
the last four recessions. The message is that a
decline in stock prices need not predict future
economic difficulties.
In this case, the
complexity of the debt instruments may prevent
countermeasures from effectively preventing a
recession. In the "old days" of the 1990s, a local
bank might have negotiated with a homeowner,
reducing the mortgage payments and avoiding
foreclosure. Without new legislation, this is
difficult as the mortgages are owned by many
parties; the payment collector does not own the
mortgage and cannot easily negotiate with
homeowners.
Other debt instruments are
similarly complex, and it just may be that like
the sorcerer's apprentice, we have created things
we do not understand and cannot easily control. If
that is the case, the stock markets may be telling
us something correctly this time.
David Dapice is associate
professor of economics at Tufts University.
(Copyright 2008 Yale Center for the Study
of Globalization. Republished with kind permission
by way of Policy
Innovations.)
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bought, bundled, and
then sliced and diced these mortgages into
different risk classes, selling them to hedge
funds and even central banks. 
