It was only ‘a’ great depression, after all…

…because it seems another one could well be around the corner. The World’s Most Prestigious Financial Body, they call it, and the Bank for International Settlements is down on global prospects. In their annual report, released yesterday – you might want to just go for the overview, though.

The report suggests quite a lot of things. It states that the global expansionary trend (around 4%) ought to continue, perhaps slowing with the US. It contains the understatement due any economics report worth anything at all (my favourite, “The impact of the downturn in the US housing market might not yet have been fully felt”). It is focussed more than anything – which is unfair of me for a start, for a report of this nature – on cheap credit, and something to which they refer as “increased risk appetitite,” which I would sooner call, say, “greed.” And here are where the parallels to the Great Depression enter the picture.

The Bank’s report is wary of a few things, in particular:

  • The US’ Current Account Deficit, the financing for which, “…as well as private capital outflows from the United States, continued to be available at terms that seemed to factor in expectations of only a very moderate further depreciation of the dollar.” This is at the same time that the US’ reliance on capital imports (below) and the varied pressures potential placed on its interest rates (government borrowing among them) makes the US dollar quite vulnerable on the ForEx market. Meaning higher depreciation ought to be allowed for in those financing plans, for us to be assured those obligations can in fact be met.
  • Continued gambling on risky debts, including the Frankendebt CDOs (I like that term), the consequence of hedge funds and private equity types chasing ever higher yields. This “appetite for risk” is one of the bigger links the Bank makes to the 1930s. Specifically, the murkiness of the banks awareness that they are generating components of bonded, on-sold securities is a disincentive for adequate protection against risk (the stopping of this, and squeezing of new home loans, is one of the effects, finally, of the hedge funds’ over-exposure to sub-prime mortgages).
  • China’s utter lack of structure or order in its financial markets, even as it amasses trillion dollar reserves, is going in for Sovereign Wealth Funds, something the IMF is beginning to follow closely as well (not just China, but generally). The scale of firms losing money (40%) in China also prompts parallels to the bad-governance banking crises of Japan in the 1980s and SE Asia, 1997.
  • The rate of leveraged buy-outs, and the debt:cash-flow ratios involved, a result of the race for high returns amongst private equity investors. The Bank’s suggestion is that this lasts only as long as cheap credit. I tend to feel it will last only until equity firms begin to proliferate and Private Equity runs out of things to buy and people to whom to sell them. I take the Bank’s point – with cheap enough credit, the cycle literally could just continue, with take-over bids and degrees of leveraging getting higher and higher (as would, incidentally, exposure to debt).

Of the capital importers, nobody comes near the US:

US capital imports

And of the exporters, China is streets ahead – which any reader of US newspapers would already know.

Capital exporters

Although Japan is in the same league, more of its capital is exported to its neighbours (though not most, and that’s another problem for another time – Japan’s capital exports are not as high as their current account surplus – insufficient recycling of capital between Japan and Asia). The Bank recommends a few things, in response to these.

  • Clearly some sort of control in China, before things get out of hand. Also some proper structural reform of their currency exchanges (related to the next point)
  • Some fiscal restraint, particularly by the countries with big CADs. The chances of reducing global current account imbalances in an orderly way would also seem to be enhanced by more exchange rate flexibility, and by structural changes. Countries with current account deficits need to focus on the production of tradables, and those with surpluses on non-tradables. In this respect, neither the past strength of the housing sector in the United States nor the current strength of the export sector in Asia can be judged wholly welcome. That’s a big recommendation, when you line the modern economies up against their declining manufacturing sectors.
  • Attack-levels of interest rates, to deal with the burgeoning levels of inflation we thought Bill Clinton and Alan Greenspan had defeated. This relates also to those CADs, and the plans for financing them.

The Bank is only suggesting, really, that there’s a 1930s-style depression in the offing if none of this is done. Many of these issues – cheap credit, over-exposure to under-considered risk, current account imbalances with bad forecasts for financing – were around at the time, and ignored (partly monetarism, partly because there hadn’t really been a depression before I suppose).

I’m obviously taking some degree of hell-bound pleasure in hedge funds and Private Equity over-extending their greed, but I would be surprised if a depression truly arose. I think the exposure of pension funds to instruments like CDOs is something managers of those funds need to address as quickly as they are still worth anything. Certainly inflation needs to be held down, but the Federal Reserve faces a bundle of obligations attached to its rates from now into the near future, so I don’t envy them that job. Meanwhile savings rates in the US are just atrocious, but their economy depends upon consumer spending – not a choice I’d want to have to make.

It’s clear that the insuperable bulk of capital travels between China and the US – could a tanking US merely take China down with it? If China can safely diversify its reserves, limiting exposure to US treasury debt, the US might just bomb on its own. A colleague of mine expressed confidence that when the worst happens, the US will take the one course he seemed they were perfectly willing to take – not pay. And who’d make them? Hopefully, nobody. Because that would be worse.

Most days I’m with the crowd that says if the US can just make it past the tenure of George Bush, the next person is bound to be smart enough to fix things – deal with housing, deal with consumer debt, remember what a balance budget was, get rid of, yet again, 30-year bonds. Regulate, for Cliff’s sake, hedge funds and private equity.

It’s actually a long list. I accept though that this isn’t only kind-of-likely. Certainly the GOP, but honestly many others in Congress, seem to have found a way to reverse the old statistics rule. They display wisdom without knowledge, knowledge without information, and information without data. I wouldn’t trust them to fetch my mail in while I was on holiday.

Of all of this, for me, the sovereign wealth funds are the most random element. They push around phenomenal amounts of money, even by today’s standards, internationally by design, definitely preying upon other country’s attempts to use monetary policy for domestic macroeconomic purposes – without so much as a codified list of best practices. I think the three of them – sovereign wealth funds, hedge funds and private equity, are going to find themselves the topics of discussion at G8 and other meetings, soon enough. Hopefully before they generate real instability.

The bookends, finally, of the Bank’s report:

The favourable global economic performance seen in recent years extended into the period under review. Global growth was strong and there were even welcome signs of better balanced demand. The US economy slowed somewhat, largely due to a weaker housing sector, while domestic demand in Europe, Japan and a number of emerging market economies picked up. Although output in many countries seemed to be close to potential, and commodity prices rose still further, overall inflation pressures remained muted. In this environment, there was a moderate tightening of monetary policies in many countries, although overall monetary and financial conditions remained highly accommodative. In part this was due to real policy rates remaining rather low, with associated effects on long-term interest rates. But it was also due to an increased willingness of lenders to advance credit to high-risk borrowers with less onerous conditionality than in the past. While the credit cycle has peaked in the subprime mortgage market in the United States, the expansion has continued in most other areas. As a result, global asset prices either continued to rise or were maintained at unusually high levels. Moreover, financing for the US current account deficit, as well as private capital outflows from the United States, continued to be available at terms that seemed to factor in expectations of only a very moderate further depreciation of the dollar.

The consensus economic forecast expects the recent excellent global performance to continue. Yet at least four sets of concerns can be raised, even if our capacity to calculate both their likelihood and possible interdependence remains limited. First, a rise in global inflation pressures cannot be ruled out. Second, the current slowdown in the United States might prove more significant than expected and the global implications greater. Third, global current account imbalances, together with large and volatile capital flows, indicate an exposure to disruptive exchange rate changes with potential implications for financial markets as well as asset prices. And finally, with most asset markets already “priced to perfection”, any unwelcome shock might have unexpected consequences.

In the face of such uncertainties, formulating macroeconomic policy in a forward-looking way is not easy. Moreover, the difficulties are compounded by ongoing debate about the appropriate role for monetary and credit aggregates in conducting monetary policy, as well as the desirability of pre-emptive action in responding to procyclicality in the financial system. That said, against a backdrop of concern about both overall global inflation and evidence of increasing financing imbalances in many areas, tighter monitoring and financial conditions would seem called for. Similarly, more fiscal restraint could have welcome short- and medium-term implications. Evidently, countries with large current account deficits should be in the forefront of such tightening moves. The chances of reducing global current account imbalances in an orderly way would also seem to be enhanced by more exchange rate flexibility, and by structural changes. Countries with current account deficits need to focus on the production of tradables, and those with surpluses on non-tradables. In this respect, neither the past strength of the housing sector in the United States nor the current strength of the export sector in Asia can be judged wholly welcome.

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