Eventful Year 2008: Descending into the Precipice

Eventful Year 2008: Descending into the Precipice
Arun Kumar
CESP/SSS, JNU, New Delhi 110067.
Published on January 5, 2009 on Taxindiaonline.
http://www.taxindiaonline.com/RC2/inside2.php3?filename=bnews_detail.php3&newsid=8395

Year 2008 began with all round predictions of reduced but positive growth for the world economy. The US economy was expected to continue to grow even if anemically. Mr. Paulson, the US Treasury secretary and Prof. Bernanke, the Fed chief prognosticated that the problems faced by the US economy were tractable and certainly not systemic – something they admitted only on September 19, 2008.
2008 is ending with rapidly rising unemployment and houselessness due to foreclosures and a deepening recession in the USA. The trend is no different in the other major world economies. Some have suggested that this is just the start of a major downturn in the world economy. Fears of deflation in the world economy are real with prices softening and this could head the world towards a depression and a recovery many years away.
The US financial system is no more what it was even six months back. Major entities like, the housing mortgage giants, Freddie Mac and Fannie Mae, the insurance giant, AIG, the largest US bank, Citibank, the giant investment banks, Goldman Sachs, Merrill Lynch, Lehman Brothers and Bear Sterns, have faced collapse. They have had to be bailed out by the government or gone bankrupt. Given the inter linkages the effect on the real economy has been sharp. The rest of the world has been hit hard by these events.

GOVERNMENT INTERVENTIONS: TOO LITTLE, TOO LATE.
USA, Euro zone, UK and Japan are all in recession while China and India are slowing down rapidly, in spite of the massive interventions by all governments which according to one estimate exceeds $10 trillion - about one sixth the size of the global GDP. The slide in the world economy is continuing even though under normal circumstances this would have led to hyper inflation – times are clearly abnormal.
Each time the US government felt that it had licked the problem - tax cut in February, bail out of Bear Sterns in March, take over of Freddie and Fannie, bail out of AIG and then of Citibank - fresh problems erupted soon thereafter. Finally, when the unprecedented bail out package of $700 billion was announced on September 19, it was felt that the collapse would halt. But fresh packages have had to be announced and now it is suggested that the U.S. President elect, Mr. Obama, is planning another package of $800 billion. The gravity of the situation maybe gauged from the announcement by the Fed that it will print as many notes as would be required to stem the collapse.
Each time, government intervention has been `too little too late’ so that the crisis has continued to deepen. The stock markets have responded temporarily till the next bad news. Most policy makers and analysts have been in a state of denial so that rather than anticipating events they have been surprised by them. This could partly be because they wished to avoid panic but the effect has only been a worsening of the situation due to lack of timely actions.
One of the key reasons for the spread of the contagion is the interlocked nature of the balance sheets of the various economic entities. Today, almost any seemingly healthy company can soon head towards trouble because it is not able to recover money from some other entity to which it has extended credit and which is failing. Hence trust has evaporated and credit has frozen almost all over the world and made central bank interventions ineffective. The delay in a decisive response from the US since it has a lame duck President is likely to prove expensive since toxicity in the financial system would have spread further by January 20, 2009 so that even more drastic intervention would be required then.

FINANCIAL FRAUD
The recent discovery of the audacious Ponzi scheme run by Mr. Madoff of the USA, resulting in losses of possibly $50 billion to various entities is going to aggravate failures and fresh problems will appear. Losses have been incurred by charities, universities, individuals, asset management funds, etc. Not only will pensioners and university students be affected, the viability of some of the companies involved will be dented and some of the smaller entities may head towards bankruptcy.
The Madoff fiasco shows that those who were supposed to be alert on behalf of the public - auditors, SEC, etc. - were possibly taken in by the swindle (a charitable view) or were a party to it. It highlights the all pervading desire to make a quick buck with little regard for risks. Since others were making money it was a good enough excuse to take unacceptable risks and make money.
While Mr. Madoff committed fraud and more such frauds maybe discovered in the coming months since there were many clever people who were hoodwinking others and making a killing for themselves, the crisis is deeper than fraud. The problem lies in the way the financial system was functioning.

DO WE REALLY KNOW WHAT TO DO?
Some have argued that because the world faced the depression of 1929, we know what to do. Namely, go in for massive fiscal intervention through the creation of fiscal deficits to boost demand. However, even this may not work since the nature of the crisis is different from the earlier one. There was lack of demand and the lesson learnt was to intervene counter cyclically to reinflate the economy.
This time while the deficiency of demand initiated the problem in the financial system that was only a trigger for the collapse of the current financial system. The collapse itself is not due to the deficiency of demand but linked to the structure of the unregulated financial system which has a built in instability which is now playing itself out. The financial bubble inflates gradually but deflates suddenly. This leads to loss of trust and collapse of confidence which then pulls the rug from under the feet of the financial system. The financial markets then freeze so that even Central Bank’s and government’s interventions fail to revive the economy.
The world economy can still produce the output it produced in June 2008 – the factories, offices, fields, etc., are still there – but the system of production which is based on finance to lubricate the flows of goods and services has been disrupted and hence the real economy has been dented. The real and the financial sectors are interlinked and the latter is taking the former along with it. Since the government announced interventions are too little too late and unable to prevent the collapse of the financial sector, the real economy is also not responding to the steps announced till now.
The problem stems from the fact that while each financial transaction is separately reversible, the totality of transactions is irreversible due to the complexity involved. Further in a situation of a freeze in credit markets, governments do not have the resources to cover the losses of all the entities or even most of the losses of some of the major entities.

IN FOR A LONG HAUL?
With spare capacity emerging everywhere and as slow down accelerates, many factories are shutting down or working fewer hours. In this situation, investment plans are bound to be frozen, as reports suggest and demand falls further. This suggests that any chance of a turn around any time soon is bleak. Unless demand begins to turn around and unutilized capacity worked out of the system, investment levels will not recover.
Government interventions have largely helped the financial sector because policy makers are mostly financial experts. But this will neither help raise basic demand in the real economy nor shore up trust and confidence in the shattered financial system because what the government can provide is a fraction of the total losses being incurred. Consequently, the recession can only deepen.
As recession deepens, commodity prices will weaken. Petro goods prices are a case in point. In spite of the slow down having just started, crude oil prices have fallen by a massive 70% from their peak. Many other commodity prices would also fall substantially since their prices had also climbed sharply till 2008 middle. There is an underlying worry of a deflation and if that happens a depression would be inevitable.

INDIA AND CHINA AND ABSENCE OF DECOUPLING.
The Chinese economy has slowed down rapidly due to its dependence on exports. Indian economy which is less dependent on exports has also slowed down. Confidence of investors has been dented by the sharp decline in the stock markets triggered by the withdrawal of funds by FIIs and reduction in the flows of FDI. With gaping holes in the balance sheets, companies need funds to shore up their accounts so they are willing to sell assets even at a loss. Further, since these markets had gone on a speculative boom and were overly priced, it pays to leave early rather than late setting up a herd mentality.
The exporters of primary produce - the developing world, petroleum exporters, etc. - will be hit hard by this decline in commodity prices. In India, Bellary iron ore mines have seen activity drop from a reported 15,000 trucks per day to just a few hundred trucks per day – a drop of more than 95%. Many plants have announced planned monthly closures or reduced the number of shifts. The over heated real estate markets and construction industry have taken a severe drubbing and along with that the cement and the steel industry. Tourism, hotels, transport, finance, trade, consumer durables, etc., are declining.
If the rate of growth of the major economies of the world falls by one per cent, then China and India can compensate for that only if their rate of growth goes up by at least 10 per cent. Given that they were already growing at possibly their peak rates, this possibility never existed so a decline was inevitable. Further since the two depend on exports to the advanced countries, their growth was bound to slow down and worsen the situation.

INEFFECTIVENESS OF POLICY INTERVENTIONS
The collapse of the British Pound, the decline in the Euro and the rise in the dollar has been the response of the crisis ridden financial sector. In spite of the weakness of the US economy, the dollar seems safer than other currencies. Investors feel that the other economies will sink more than the US since the big loses the least. Further, the confusion in the Euro zone due to competing national interests has reduced the chances of a coordinated response so that Europe could suffer badly. In contrast, the US does not face this problem.
In times of crisis, theory suggests that economic entities facing uncertainty go liquid and that is what we are witnessing all over the world. Hence interest rate cuts do not stimulate the economy. Release of liquidity by Central Banks is simply being held and not circulated – money multiplier and the velocity of circulation have collapsed leading to a freezing of the financial markets.
Central banks and governments are liberally promising money to companies without any risk assessment. They have become the lender of first resort to the financial sector and are no more the lenders of last resort as required by banking theory. Are they equipped to assess the risks involved, etc.? In any case, it takes a while to decipher the balance sheets made by clever accountants and lawyers who have devised myriad ways of hiding holes in the accounts. AIG has absorbed $150 billion in the months since September, 2008 but hardly anyone understands where the money has gone and how much more may go.

NEED FOR GLOBAL COORDINATION
The stimulus package of one country may fail due to inaction by others so that there is need for global coordination. Action by one may benefit another due to the global nature of the economy and the former may be left with deeper problems. This is likely since different views of what needs to be done prevail. Mr Obama’s non participation in the G 20 summit in November is an indication that he did not see eye to eye with Mr. Bush. Germany has been critical of Britain. China has hinted at moving away from the dollar since it has suffered big losses. Iceland froze British assets and the latter declared the former a terrorist state. The US rapidly losing jobs could go in for protecting jobs by making retention of jobs in the USA a condition for bailing out companies. All this is pointing in the direction of protectionism.
While global coordination is essential it is necessary but not sufficient for recovery. The problem is, policy makers do not quite know how to resolve the crisis. Understanding of the past is useful but inadequate given that the core problem is not what it was. Policy makers have to get out of their state of denial and the hope that somehow the crisis will blow away – we are not in the world of inevitable happy endings.

CONCLUSION
The world cannot do without the financial system that is essential for investments and trade to occur efficiently. This basic function of the financial system was eroded by the various imaginative innovations in the financial system and led to collapse. These were supposed to lower risk but now it is clear they ended up enhancing it.
There is need to restructure the global financial system completely. The present system has completely lost credibility with the citizens and investors. Trust is not likely to return any time soon given the kind of losses that have been suffered all around – running into trillions of dollars. Experts are no more going to be acceptable to the public since they have proved to be too clever by halves and caused enormous losses to their clients.
The complex financial system was treated by the vast majority of the investors as a black box and faith laid on it because the experts said so. This opacity did not matter as long as money was being made but now the public would demand transparency.
In fact, as is now clear, most policy makers themselves did not fully understand what was going on. Alan Greenspan has admitted this. Demand for proper regulation of the complex financial system is likely to grow so that the powers of the Central Banks are likely to be enhanced and more policy intervention maybe acceptable. The fragility of the financial system would no more be acceptable. A long term view would have to be taken since it is now clear that short term profits with eventual collapse is worse than a steady return. All in all, we are in for a long haul and in 2009 we are entering a world substantially different from the one we started with in 2008.