Hard times are ahead – and they won’t be over soon. 

Listener: 1 November, 2008. 

Keywords: Macroeconomics & Money; 

The financial boom is over, as is its artificial stimulus of the world economy. Its excesses are unwinding in a broadly predictable manner. I can’t tell you the exact timing, nor the details. but we have many more phases to go despite repeated promises it is all over. 

The Liquidity Crisis: The liquidity crisis started in August 2007, when financial institutions could not convert good–quality assets into cash. Central banks responded by pumping more cash into the system. However, the liquidity crisis has not gone away, because of the next stage, which is … 

The Balance Sheet Crisis: Balance sheets match assets against liabilities. Sometimes they don’t match properly, when some of the assets prove to be of poor quality (their value is uncertain). If others fear a financial institution has a poor-quality balance sheet, they won’t trade with it. The institution may go bankrupt, in which case its shareholders lose their equity, and investors lose much of the value of their deposits. It may be taken over or nationalised. The Government may split it into a “good bank” and “bad bank”, with the latter containing the poor-quality assets. The share-holders may lose some of the value of their equity (depending on the generosity of the Government). 

The Run on the Banks: Even banks with good-quality balance sheets suffer when investors panic because of false rumours and start withdrawing their deposits. As the bank will not be able to cash up its assets (say, mortgages) as quickly, it runs short of cash. It may sell some assets to other institutions, including the central bank. In order to prevent these runs, which can be deeply disruptive, the individual depositors in all rich countries have received guarantees from their governments. New Zealand’s guarantee seems comprehensive. If the banks are even more problematic, the Government may inject equity into the bank (purchasing -preference shares), in effect partially nationalising it. 

Contagion: Runs on banks can be irrational, so they will happen elsewhere. We await difficulties in Asia and Latin America, which will be compounded if they also have balance-sheet problems. 

International Difficulties: Some central banks may find themselves in difficulties (short of the required foreign currency), as happened during the crises of the 1990s. The International Monetary Fund, the US Treasury and the European and Japanese central banks (among others) get called in. Iceland may be only the first. 

Collateral Damage: This occurs as innocent institutions find themselves caught short. The State of California cannot raise its usual seasonal borrowing; Americans dependent on company pension funds will be in trouble. 

The Economic Downturn: The world economy is already moving into recession with workers in the finance, real estate and building industries being laid off. Those who have lost savings are -cutting back their spending, and corporations are having difficulty borrowing for new investment. New Zealand will suffer reduced income from its exports, especially tourism as wealthy overseas travellers put off holidays, and as commodity products prices fall. As more people become un-employed there is a danger of a downward spiral. This is when government should increase public and private spending, although the package should depend on the particular circumstances. 

Recession or Depression? We don’t know which. Any world recession will probably be long – perhaps two years. 

The Ideological Crisis: For the past half century, the most raucous ideology has been that the private pursuit of greed is socially beneficial. Its advocates seem so shocked by what is happening (or fearful of losing their fortunes), they are just as keen to use governments to protect their interests as are the ordinary people they used to abuse. The succeeding ideology may be a modified form of social capitalism. It may last half a century (as occurred after the Great Depression in the 30s). 

The New World Order: The US economy will not be as dominant in the evolving world economy. Instead five or so big economies will compete for power.