It's odd that so many people in the financial community seem already to have
lost track of what really happened in 2008. The reason perhaps is that the year
has by now been politicized and over-analyzed to where most of us are tired of
the commentary and are no longer paying attention. Yet 2008 is still with us in
a very immediate way, as is 2001, 1998, 1994 and all the other points of sharp
market inflection that have occurred within the career-spans contemporary
players. Financial historians will want to look back still further to at least
the 1913 founding the American Federal Reserve system, a development that would
over time give rise to the dollar-based international monetary system. The
institution that was supposed put an end to financial panics, as they were
called in those days, instead helped lay the groundwork for systemic
instability, a more contemporary term-of-art for roughly the same thing
unfolding through high-speed modern markets.
I want to focus on 2012 and not torture history any more than necessary. Past
chains of events, however, always suggest clues to the future and are thus
usually worth the time to consider. Several common factors have percolated
through past crises, but the one that stands out to my mind above all others is
the existence of linchpin events. These are small developments that
seem minimally significant upon first appearance, but that spin out of control
and, through obscure interconnections, trigger improbably large events.
Looking back to a couple of years prior to 2008, for example, mortgage
analysts will remember that the default rates for subprime mortgages began
creeping upward and were soon outside the "worst case" boundaries established by
the investment bankers who were structuring mortgage securities. Insiders began
taking note, but few people on Wall Street or in Washington were overly
concerned, because the problem appeared to be manageable. It was only
manageable, of course, until it wasn't, when projected financial losses
began to extend beyond the relatively small sub-prime mortgage sector. Then
suddenly awareness dawned about how leveraged the entire financial system had
become. The succeeding chain of events needs no recounting here, but the end
result after a couple of years was the virtual nationalization of supposedly
indomitable banks in the U.S. and Europe, political realignments on both
continents, and the dawn of what journalists later dubbed the "Great
Recession".
For the past three years the search for new linchpin events has been a
favorite dinner-party sport among retired financial types, and a survivalist
challenge for people still on the front lines. Now in May of 2012 a couple of
developments have appeared that to my mind suggest themselves as serious
candidates.
First is the latest devolution of the situation in Greece. This
crisis, of course, has been with us for the past three years. Hardly a slow news
day has gone by without pundits attributing either small market upticks to new
optimism that a Greek resolution is in the works, or else downticks to erosion
of optimism that had supposedly been there the day before. As with a slow-moving
cancer, Greece has found its way to the periphery of consciousness for most of
us, but will not to go away. The news now is that new elections will be
necessary due to the evaporation of whatever frail national consensus there had
been to go on collaborating with the northern Europeans. We should remember that
what we're dealing with here is not a normal country, however pretty its Aegean
islands may be. Greece faced a communist insurgency in the years following WWII,
suffered a fascist coup d'etat in 1967, and was living under military
dictatorship as late as the 1970's. Political turbulence is not street theater
for these people but serious business. The thought of elections in the current
climate, with extremist parties gaining strength again, is unsettling.
I'm no sovereign expert, but it doesn't take a weatherman to know which
way the wind blows here. The Greeks and the Germans can no longer
tolerate one another, and at the very least it seems we can expect that Greece
will exit the eurozone. At that point a couple of ugly genies will be out of the
bottle. First, the ties that bind the eurozone together will no longer appear
sacrosanct to other member states who might be quietly considering the same
option. Secondly, once they have their own currency back, we can expect the
Greeks quickly to exercise their new prerogative to debase it. That, after all,
is the point of monetary sovereignty for a failed nation. To a continent, and a
world, overburdened with debt, little Greece will have demonstrated how easily
fiat money can lighten the load. The re-appearance of hyperinflation in Europe,
even in a small country, will reverberate loudly.
The second potential linchpin event currently in the news is the J.P Morgan
situation. In a matter of a few days, there has already been too much commentary
about this from people with little information about it, and I'll try not to add
to the noise here. However, the sudden announcement that even Jamie Dimon's bank
doesn't know how to execute a hedge is devastating news for market participants
who had been hoping that adults were back in the room and that our modern
capital markets were regaining their equilibrium. As Dimon knows, he will now be
compelled to hand over his sword to the politicians who, in a presidential
election year, are more eager than ever to demonstrate their zeal in punishing
Wall Street.
And for anyone who takes comfort in the prospect of increased regulation, I
can only point to the dog's breakfast that still sits largely uneaten on the
table in the form of the 2010 Dodd Frank legislation. Paradoxically both
over-engineered and unfinished, this body of law arms regulators with powers
that are as vague as they are powerful. Implementation will now proceed with a
renewed directionless vigor. Regulators will find themselves operating in waters
that are dark and over their heads, but they will nonetheless feel compelled to
act boldly. None of this bodes well for financial stability.
For investors, the main lesson of 2008 was that in the midst of systemic
instability, a decade's worth of hard-earned gains can be wiped out in a
matter of weeks. In my view, the conditions are now in place for another
collapse of equal magnitude, perhaps without the sovereign willpower this time
to engineer another quick recovery. Investors, however, have no clear safe
havens. Gold, the classic panacea for dangerous times, lost money in 2008 and,
after big gains during the recovery, is losing money again now. Inflation and
low interest rates are eating away at cash and bonds. Short strategies can be
disastrous if the timing is wrong, and obvious trends rarely follow obvious
timetables. Problems could easily come to a head by the end of this year, but
could still drag on, depending mainly on political variables.
5/18/12
Why I Disagree with Doomsters
There are 3 main fears driving the current stock market
decline. I think each of them may materialize, but either the odds are against
them being serious impediments to future growth, or the impact of their
occurrence is exaggerated. This discussion therefore focuses on those reasons:
Risk 1. Europe The fear is that Greece will reject
the EU deal and drop out of the Eurozone, thereby triggering the same from
Portugal, Italy, Ireland and Spain. Any significant part of that avalanche
would destroy the euro and severely damage the entire European economy,
plunging Europe into a major depression.
I think that the new Greek government and the Germans will
not chase each other over this cliff, but rather the deal previously made will get
adjusted. Basically, the German and French banks are now eyeball to eyeball
with the Greek people, and I think I just saw Merkel and the German voters
blink. Moreover, an adjustment would be appropriate. The current deal is based
on a moralistic view of what happened in Greece and how Greek public employees,
tax avoidance, and corruption are to blame for the mess. Consequently, the
northerners felt justified in imposing economically senseless austerity
requirements. In reality, I think the bankers who made loans without evaluating
risks properly are just as blameworthy, and therefore the draconian
requirements of the Greek deal are severely unfair. That moves the issue from morality to politics, where fairness
is a major concern. And the political reality is that if the northerners want
to save the euro, which has been tremendously beneficial for them, they must
bow to political reality and make a fairer deal. They seem to be moving that
way, and since they have more to lose by refusing, I am pretty sure they will
do so.
Even if the Greeks do drop out, the direct impact on the
rest of Europe would be minor. So, that leads us to the contagion issue. The
other countries at risk are very different than Greece. They do not face the
same moral onus, and of course the risks to the northerners are much, much
greater should the defaults spread. Accordingly, especially in light of the
very substantial funds that have been allocated to protecting Europe from
further financial disaster, I think the possibility of continued demands for
austerity, and contagion, is quite low. There will, of course, be much shouting
and finger pointing, and the words could get ugly, but in the end I still think
the northerners will cut a deal that the southerners and Irish regard as fair.
Bottom line: I think there is only about a 15% chance that
Europe will swirl itself into a new depression.
Risk 2: China The risk here is that China’s growth
rate slows and, longer term, that China’s potential political, environmental,
and economic difficulties become unmanageable. In other words, that it ceases
to be a growth engine for the world.
Although China is huge, and manufactures an enormous amount
of what the world consumes, it is not as economically important to the world as
its population and manufacturing capability would indicate. It consumes far
less than its size, population, and manufacturing prowess might indicate.
Moreover, short of civil war, a most unlikely possibility, China’s slowing
growth rate would have little effect on the manufacturing sector as far as the
rest of the world is concerned. And if necessary, much of that manufacturing
could quickly shift to other countries, including the US, as it certainly will
anyway over the next couple of decades. China is a huge factor in world trade
because of its manufacturing sales abroad, and the shipment of materiel into
China to support that manufacturing. But as a market, China remains much
smaller.
The Chinese economy, slightly larger than Japan’s in GDP
($5.9 trillion to $5.5), depends much more heavily on trade. Specifically, its
imports total $1.587 trillion compared to $2.592 for the EU and $2.336 for the
US. Most of what it imports, however, goes back out in exports. As WTO data
notes, Trade is 55.2% of China’s GDP compared to 29.8% for the EU and 27.8% for
the US. By contrast the consumer
markets in the EU and the US are much larger, with GDPs of $16 and $15 trillion
compared to China’s $6 trillion. Back out the share of GDP represented by trade
and the differences are even greater: $11.23 trillion for the EU, $10.83
trillion for the US, and $2.69 trillion for China.[1]
So while a serious slowdown in
China seems 50% possible, and would have an impact, the impact would not prove
especially large or scary.
Risk 3: Congress The third, and in my estimation the
largest risk of all, is that US politics will prove
extremely destructive to the economy.
The risk comes basically from gridlock on two
matters. First, if Congress fails to decide on the debt ceiling in a timely way, it will create major uncertainties
for domestic and foreign firms, causing a serious decline in investment spending, perhaps private consumption, and public tax revenues and spending. Second, the draconian tax increases that
would take effect if the politicians cannot reach a budget agreement would
significantly reduce US purchasing power, a problem exacerbated by reductions
in public spending at both state and federal levels. The impact on perceptions
and the willingness of firms and consumers to spend (a failure of economic demand
that leads to depression) could be even greater. It is hard to estimate the severity of the economic decline
that these failures would trigger, or even the timing, but given the track
record of Congress, the positions the candidates and politicians are
announcing, and the ideological fervor that many are showing, the risk seems
quite large.
As with Europe, however, I cannot believe that the politicians will
pursue insanity to the ultimate degree of economic destructiveness. With a
Presidential election looming, I think their incentives cut both ways. That is,
the Republicans would like the economy to slump because it would hurt Obama’s
election chances. On the other hand, they don’t want the blame by appearing
intransigent. My best guess is that they will find compromises to “kick the can
down the road” and let the election and the next President handle the issues.
In other words, they will not let economic catastrophe overwhelm their
candidate’s chances at the end of 2012. Consequently, I rate the possibility of economic disaster
occurring in the near future because of Washington gridlock as no higher than 50-50. But this is the only one of the three main present risks that I find gravely troublesome.
[1]
Source: World Trade Organization, Country
Profiles. http://stat.wto.org/Home/WSDBHome.aspx?Language=E accessed 5/18/12.
Note: EU trade data excludes trade within the EU.
Subscribe to:
Posts (Atom)