The Crisis of Credit Visualized

If you're looking for a fun and easy-to-understand explanation of the causes of the credit crisis, check out this cool video produced by Jonathan Jarvis:

Commodity price collapse: who wins and who loses?

One of the great back stories of the ongoing economic crisis is the collapse in commodity prices, which occurred in the second half of 2008 after a record boom period lasting at least five years. The bursting of the bubble has produced clear winners and losers. Thanks to our fantastic contributors, zzzeitgeist has had excellent coverage of these repercussions. I thought I’d try to tie things together.

The biggest winners are consumers, particularly first-world automobile drivers. In the last 7+ months, oil has fallen from $147/barrel to about $37/barrel now. Economists reckon that amounts to a ‘stimulus’ of more than $240 billion. Also, now that the world food crisis has largely subsided, developing-world consumers stand to benefit from cheaper food prices. This means a lot when you spend more than 50% of your budget on food.

The mining sector is obviously a huge loser. Mining is often a boom and bust industry, because it takes a long time to develop new mining projects. It’s hard to forecast future supply/demand fundamentals (remember when this seemed like a good idea?) and unfortunately they can change drastically and rapidly, which is exactly what has happened in the last year. As a result, a number of firms are closing mines, because prices are too low to justify operating costs. Mining firms often take on a lot debt out of necessity – digging mines ain’t cheap. But thanks to the financial crisis and the disappearance of cheap credit, heavily indebted companies are suddenly struggling to stay afloat. Case in point: Rio Tinto, the world’s second largest mining conglomerate. See Rory’s excellent treatment of Rio’s debt woes here.

Finally, commodity-dependent countries suffer perhaps the worst. When prices are high, resource-rich countries are suddenly flush with cash, which they can use to advance geopolitical aims, reward cronies, or invest in infrastructure, education and health to avoid the resource curse (don’t hold your breath). Falling commodity prices have scaled back these ambitions. See Dan’s analysis of Venezuela, Rory’s take on Russia, or this money quote about Iran.

In my mind, these are the biggest winners and losers, but this list is by no means exhaustive. Falling commodity prices also have an enormous effect on agricultural trade, international cooperation, foreign direct investment, Guinea, South Africa, Australia, several Latin American countries, etc. Who else am I missing?

(photo from jeff-o-matic’s photostream)

Credit markets seize... trade slows down?

As I noted the other day off-handedly, when we think of economic globalization, we tend to think of the two pillars of international finance and international trade. At LSE, we generally studied them as related, but distinct phenomena. Let’s put it this way: you know how you can get through English 101 by chanting “four legs good, two legs bad?” You can get through grad school by repeating ad nauseam the mantra “trade flows good, portfolio capital flows bad.”

I keed, I keed. But seriously, most academic economists acknowledge that trade is an all-around beneficial economic driver, whereas the record of finance (capital flows) is a bit more mixed.

Which is why I was so surprised to read about an unexpected knock-on effect of frozen global credit markets: the cost of financing international shipments has skyrocketed. In a nutshell: nobody wants to lend money to exporters to cover up-front shipping costs, even though the ships and cargo are put up as collateral (maybe lenders are afraid of pirates?) Unfortunately, in the real world, trade and finance are not quite the neat, separate spheres we study in the classroom.

This is a sobering development, one which has flown under the radar given the other enormous, paradigm-shifting developments that have occurred in these strange times. (Partial nationalization?!? Really??) But it is an indicator of just how bad things have gotten, and it gives a glimpse of how difficult it might become for the world economy to function, should these government-led rescue initiatives fail. A world where finance problems strangles trade is enough to send shivers down my spine.

(Photo by akpt)

The financial stakes of inaction

Long-time Zeitgeist (and real life) friend Matt points to Jeffry Miron’s commentary on CNN in response to the rant I posted yesterday. Mr. Miron argues, in essence, that the bailout is a poor idea and that insolvent financial firms should instead declare bankruptcy. Why should taxpayers prop up failed firms that made reckless decisions? In a free market, winners are rewarded, and the losers fail. That’s how it ought to work. I’ve heard this argument from a number of readers and I realize that I need to do a better job of explaining why I think government intervention is necessary.

The key to understanding the importance of the bailout is framing the issues at stake. The idea of saving Wall Street financial types who should be punished (in a market sense) for their poor decisions is difficult to stomach. But this is an unavoidable side effect of the bailout, not its central intent. The bailout essentially proposes that the government purchase toxic assets that nobody wants, because only the government has sufficient capital to do so. The reasoning is that by doing this, you save people who have made poor decisions, but much more importantly, you relieve the enormous pressure in the financial system and help put it on its way back to normality.

Many people think that statements like that (aka “saving” the financial system) amount to fear mongering. Perhaps they do, but the problem is that nobody knows. I believe that by doing nothing, we are taking a large gamble on a significant economic downturn. The best indicators, which are admittedly crude, as well as most financial experts suggest that there exists a massive crisis of confidence in the markets. Confidence underpins well-functioning financial markets. I think this is a point that Mr. Miron acknowledges but brushes over far too quickly. When institutions are nervous about lending money, they price that perceived risk into the interest rates they charge. During times of low (or, as it is right now, historically low) levels of confidence it becomes very difficult or much more expensive to borrow money.

Credit, in turn, is absolutely essential to the normal functioning of an economy. Every time you use a credit card, you’re borrowing money. More importantly, businesses rely on credit to smooth out consumption and meet their debt obligations (like paying workers). Entrepreneurs rely on credit to turn their ideas into the next Google. With a little imagination, it is not hard to see what happens if liquidity dries up and confidence erodes. Main Street and Wall Street are very closely tied together.

The difference is that markets are so spooked right now that evaporation of credit could happen on a massive, never-before seen scale. Willem Buiter gives a “quite likely” scenario of what could happen in the near future. It’s too long to quote here, but I strongly encourage you to read it. Tyler Cohen, one of the most level headed and reasonable people, adds a best and worst case scenario. The best case is a two year recession and 8-9% unemployment.

Again, the naysayers may argue that this hyperbolic, and that these exaggerated worries do not justify backing an admittedly poorly-designed and possibly enormously expensive rescue package (although the cost is debatable as it's an investment). I do hope that the worries prove overblown. But my own understanding of the situation, as well as the opinions of people I strongly respect, point me towards endorsing government intervention. There's no guarantee that it will work, and it certainly won't right the systemic problems overnight. But I’m still not convinced that the gamble of inaction is one worth taking.

I’ll end by quoting Steve Pearlstein’s column:

“Americans fail to understand that they are facing the real prospect of a decade of little or no economic growth because of the bursting of a credit bubble that they helped create and that now threatens to bring down the global financial system.”

Recession obsession

News is trickling in on the backs of quarterly reports that suggests Asian and European economies are not nearly as decoupled from American economic conditions as previously thought. The contagion of the American "credit crunch" is spreading and though these markets may be technically independent from the US economy (i.e. they have not bought securitized loan packages from American banks) they still face a number of problems.

The instruments of financial (not monetary - the ECB is notoriously opaque) work in Europe are close to ours. The loan bubble that caused the "credit crunch" here exists in Europe as well; it simply manifests in a slightly different form. Look at the housing markets in Spain and Britain, unemployment pretty much anywhere but Germany, and contracting export margins throughout Europe and Asia (especially China and Japan). Unlike the quick action of the Fed, the sclerotic pace of EU regulation and the inflation-bent of the ECB won't do anything to counter these effects anytime soon.

There are a number of other significant problems in what is increasingly looking like a global recession, which Larry Summers ties up nicely. But the problems now seem beyond the scope of interventionist policy. Even if they were not, I am not convinced the Fed could responsibly round up enough liquid cash to implement any type of further "injection" to buoy the economy. With more and more banks facing huge writedowns and even insolvency, the Fed cannot feasibly expand its own balance sheet. The one thing policy wonks should not be adding to the cacophony is a cry for another stimulus. The term "credit crunch" conjures up ideas that the situation would be resolved if there was simply more money around to lend out. This simply isn't the case.

The Fed "injects" money into the economy (whether it's a tax stimulus or a bail-out) by controlling the reserve supply of cash to banks. To ease short term interest rates (and thus push money) the Fed buys securities by crediting the account of their primary dealer (who is free then to lend out these reserves) thus expanding its own balance sheet. This practice, if ensconced permanently in policy, will yield disastrous results: essentially, an even greater expansion of GSEs (and not just ones dabbling in mortgages either) with bills passed to the taxpayer and profits distributed to managers and shareholders. This encourages reckless and risky investment policies which will even further undermine the financial system.

The crunch needs to be felt by those who helped cause it, not passed indefinitely down the line. Free markets need to be free in the good times and the bad. If only Paulson had seen it coming.

Credit freeze

The New York Times reported today that many banks and financial institutions are reducing business loans. This sounds justified given the IMF's most recent report that credit risk remains elevated. There is no doubt that the sub-prime mess has spread through the economy. But personal loans should and have been tightened; they contribute little to economic growth unless in the form of overvalued housing prices or discretionary purchases. To tighten access to capital for businesses is a worrying step. This constrains the private sector expansion and innovation that contributes to overall economic growth.

But despite my views on what it may do to growth, for banks that haven't been bailed out this is probably a wise move. They should be allowed to navigate the credit crisis in what they see as a responsible and fit manner for themselves and their shareholders. But banks that were "too large to fail", and rightfully bailed out, should at least be forced to give the government a seat at the table and this is a perfect example. The current crisis and new environment present a ripe opportunity to overhaul the regulatory framework. Cyclical ups and downs will not be relegated to the past but new regulation may mitigate the impacts of future downturns to one sector or aspect of the economy.

Regulation does not have to mean outright control or even lower profits. If government officials (or at least Fed overseers - partisan ideas should not be involved) were given a short term advisory and observatory role, new rules may be drawn up in a compromised manner. This temporary set up would preclude any delusions about a new waves of GSEs and result in a new class of government wonks uniquely suited to draw up and implement new regulation based on inside understanding and access to financial and bank executives.

Economic crises require new regulation and ideas to prevent misatkes from recurring. Ideology can only carry one so far; let's hope pragmatism follows.