Will There Be A Worldwide Financial Crash?
Listener: 25 August, 2007
Keywords: Macroeconomics & Money;
We cannot tell whether the current turbulence in international financial markets will continue, end or get worse. What is certain, though, is that there are serious financial imbalances in the world economy that have to be corrected in the long run.
Sometimes such adjustments occur without excessive pain, as when US presidents George Bush Sr and Bill Clinton ended the US budget deficit inherited from Ronald Reagan. Sometimes the correction leads to bankruptcy and unemployment.
The current imbalances arise from Bush Jr’s tax cuts while he increased government spending, coupled with the Japanese central bank’s low interest rate of half a percent a year. The resulting liquidity injection into the world economy has had investors looking for opportunities to invest cheap funds. As prudent opportunities became exhausted they sought higher-risk ones such as “sub-prime” housing loans in the US.
This is not a term used in New Zealand, but US banks have been providing mortgages to “Ninja” borrowers – “No Income, No Jobs or Assets” – on the grounds that, while there will be failures, enough high-interest loans will succeed to cover the failures. It is not obvious that this strategy works in the long run.
We are not sure who will suffer initially when the loans come unstuck. Simple loans have been carved up into components reflecting various risks that are on-sold to different investors with different risk requirements. So it is unclear who are the ultimate risk-takers. As the loans fail, or are seen to be in danger of failing, investors call on other investments to cover their losses. They sell shares to get the cash, depressing share prices, and liquidate loans in overseas financial markets (such as New Zealand), disturbing their exchange rates and pushing up local interest rates.
This can trigger a chain reaction, since others have difficulty selling their assets or servicing their loans. Some of those caught out may be innocent of excessive speculation – say, first homeowners – but even so, they suffer. It gets worse if people jammed for money stop paying bills, since their trade suppliers now have a shortage of cash, and cut back their orders, which reduces sales by suppliers.
The downward spiral worsens as workers are laid off. Economic activity may seize up altogether if the money required to keep the economy running is compromised by an implosion of the financial system.
This worst-case scenario is well understood by monetary authorities, About a fortnight ago, a French Bank, BNP Paribar, reported a “complete evaporation of liquidity in certain market segments”. The central banks responded by injecting billions of dollars and euros into the world monetary system. Now, initially anyway, investors do not have the same need to liquidate (turn into cash) their financial assets. But they may be frightened of failure and nonetheless precipitate further turmoil.
The injected cash does not address the underlying financial imbalances. It merely puts off the day of reckoning. Perhaps the central banks hope that the financial markets will use the time to unwind some of their more perilous positions in an orderly manner. Although markets may be somewhat more sober than they were a couple of months ago, the unwinding may take a long time. Meanwhile, the world economy could stagnate.
I have focused on the US sub-prime market, but there is a parallel threat from private-equity takeovers that have been highly “leveraged” – ie, most of the purchase is funded from loans. The financial viability of the taken-over firm becomes compromised if its earnings decline or interest rates rise and the purchase loans cannot be fully serviced. These overseas upheavals are already having an impact on New Zealand. As far as can be judged, our financial system is sound, and can bear significant pressure from the world economy. However, some local borrowers are pressured, and may be even more so if the economy slows down and unemployment rises.
The usual advice to investors remains: include a margin in your financial planning for other people’s stupidity. This time the “others” may include people overseas, ranging from the poorest Ninjas to the richest private-equity investors.