The day after tomorrow?

Since the dawn of the credit crisis last summer, fear has replaced greed as
the motivating instinct in the financial markets. The crisis has been more
persistent than anyone expected and the mood has darkened steadily.

At this point, it is widely accepted that the fallout could be protracted,
painful and damaging for many corners of the financial markets, rather than an
isolated mortgage securitisation problem.

The central view among analysts still points to an unpleasant, but tolerable,
outcome. Federal Reserve chairman Ben Bernanke has been careful to avoid using
the word ‘recession’, but central bank forecasts, including that of the Fed,
emanate fear.

Many analysts now acknowledge that the acute pessimism signalled initially by
a minority cannot be dismissed as a wild exaggeration. Since the pessimists may
just be right, Bernanke, and the rest of us, must now examine carefully those
extreme outcome theories and consider how we might cope with them.

The US sub-prime mortgage problem was ­initially seen as the result of
reckless lending which, though large, could be managed. But the credit crunch
has escalated into a major crisis because of the sheer size of losses and the
internationally interdependent nature of the financial sector.

As is now known, in modern banking practice, many loans are not kept on the
balance sheet of the bank that originates the deal. Instead, they are packaged
into securities that are then either sold to other investors in the market or
placed in off-balance sheet ‘vehicles’, thus ­making room for new business.
These vehicles are separate legal entities, but, importantly, are closely linked
morally to the originating bank.

When times were good, this ‘originate-and-distribute’ banking model had many
virtues, boosting efficiency, raising profits and spreading risks more widely.
But once the sub-prime crisis erupted and multi-­billion dollar losses came to
light – forcing some financial institutions to secure emergency funding from
central banks, sovereign funds or enact emergency rights issues to avoid a
collapse – the model failed and made the crisis worse: since no one knew where
the poor quality loans being sold were actually held, fears and rumour mounted
and banks became reluctant to lend to each other.

Off-balance sheet vehicles backed by ­mortgages were suddenly unable to
obtain funds in the markets. The banks that originated the mortgages were faced
with unpalatable choices: either allow their off-balance sheet vehicles to fail,
with huge damage to their reputation, or take the vehicles back onto their own
balance sheets, just when the inter-bank market dried up and the first talk of a
credit crunch started filtering through the markets.

Cash injection
The abrupt re-pricing of risk has created a huge global liquidity problem. In
response, the major central banks have injected huge amounts of cash into their
respective banking systems. But as events have evolved, it has become ­evident
that the central banks’ arsenal may not be ­nearly enough to handle what could
be a major ­solvency crisis, in addition to severe ­liquidity shortages.

The management style of the central banks are in sharp contrast with each
other. From the ­outset, the Fed, under huge pressure to show it was in control,
plumped for big liquidity ­injections and aggressive interest rate cuts. The
European Central Bank, on the other hand, has restricted itself to providing
cash, but has so far kept official interest rates at a pre-crisis 4%. The crisis
rolls on despite these approaches. This ­striking policy gap reflects greater US
concern over threats to growth and a more determined US effort to counter those
threats. In the eurozone, inflation remains a bigger worry. But America’s
pro-active policies have failed to end the crisis. Mortgage interest rates have
risen, in spite of big cuts in official Fed rates. The realisation now is that a
deeper US downturn – the word of choice over there – may be unavoidable even if
the Fed slashes rates to 1% or lower. If these fears are valid, the consequences
could be chilling.

Determining the scale of bad mortgage debts is a challenge and estimates of
the losses have escalated in a frightening manner, from a measly $100bn as
indicated last summer by Bernanke, to more than $1 trillion as suggested by
authoritative analysts today. More extreme figures, as high as $3 trillion, have
also been bandied around. But big falls in house prices accentuate losses from
mortgages. The decline in US house prices from recent peaks is estimated at
12.5%. Since house prices will continue falling, the overall size of mortgage
losses will be revised further upwards. If US house prices were to fall 25% to
30% from their peak, almost 10% of US household wealth could be wiped out. This
is before counting collateral damage in other areas, such as commercial property
and share prices.

In terms of spending, the most serious impact of collapsing wealth values
would be on personal consumption and further reduced investment in residential
property. More massive losses on mortgages would severely weaken the balance
sheets of banks and other financial institutions and further impair their
ability to lend.

In turn, this would further damage US ­personal spending, which depends
critically on credit.

The ultimate disaster would be a vicious spiral of plummeting property prices
and falling expenditure on consumption and investment. Mounting bank losses
would spread from ­mortgages to consumer debt such as credit cards and car loans
and eventually to business loans, resulting in widespread bank failures.

The result could be a calamitous economic downturn. Swelling losses and
falling expenditure would feed upon themselves. All this, the most doom-loving
nay-sayers predict, could mean a 1930s-type slump, with high unemployment and
falling output.

In reality, the circumstances that could produce this sort of disastrous
scenario are unlikely to materialise in their totality. Another Great Depression
is unimaginable. But many warning signals that we are in for a deep period of
­contraction persist. Other extreme, but plausible, scenarios include (a) a US
version of Japan’s 1990s stagnation, (b) an inflationary upsurge ­triggering
serious political instability, or (c) a collapse of the US dollar, default and
loss of US creditworthiness.
• A Japanese-style slump would see huge property losses causing massive damage
to the banks’ ­balance sheets. Even if the authorities manage to avoid a major
slump in the real economy, the financial damage would still be severe in the
long-term, as financial sector balance sheets would remain burdened with huge
bad debts for years. With the banks paralysed and unable to provide finance to
sound businesses, the US economy could relapse into a long period of stagnation,
just as happened in Japan. The result would be low productivity and gradual
economic decline. This scenario may be less dramatic when compared with a major
depression, but is nevertheless an unmitigated disaster for the US, long able to
claim rare business dynamism and economic dominance.
• An alternative scenario is almost at the other end of the scale: determined
efforts to avoid slump and stagnation could lead US authorities to abandon,
initially at least, any serious concern over inflation. The Fed would cut
interest rates to near 0%, it would buy a large volume of sub-prime mortgages
and accept them as collateral when providing cash, a measure sometimes described
as ‘the nuclear option’. The US Administration could introduce very aggressive
fiscal measures, both tax cuts and spending increases. All these steps would
inevitably worsen inflationary pressures, bond yields would shoot up in spite of
lower ­official rates and the dollar would fall. Then, when inflation became
intolerable, the Fed would reverse course and push up interest rates to halt the
upsurge in prices. The result could be a cycle of instability as the authorities
lose control over events and lurch into frequent policy changes to cope with
worsening conflicting ­pressures. In this scenario, economic performance would
worsen sharply and the risks of stagflation would increase.
• But what if the dollar collapsed and the US lost its credit worthiness? The
early stages of this third scenario are similar to the previous one: aggressive
policy-easing leads to a surge in ­inflation. But instead of reversing course,
the authorities are prepared to tolerate higher ­inflation for much longer in
the hope of avoiding recession and stagnation. If such policies are ­pursued,
the US dollar could collapse, not simply weaken. A massive devaluation of the
currency, as well as boosting exports, would enable the US to, in effect, wipe
out its huge external debt. While politically tempting, such a ‘default’ would
entail huge costs: an irreversible loss in credit worthiness and a disastrous
decline in its global status as a superpower. In the longer term, the policies
associated with this scenario would fail and would have to be reversed.
Growth would eventually shrink, since high inflation fosters inefficiencies.
Anti-inflation policies would prove inevitable, since the US cannot allow higher
inflation to continue indefinitely.

What does this mean for the UK? The housing market is not in freefall at
present and there is no severe housing collapse in the way things have
deteriorated in the US. But UK house prices have long been significantly
overvalued and are now beginning to fall. The thing most people thought would
never really happen is happening.

More fundamentally, the economy is facing problems and imbalances that are
similar to, and possibly worse than, those the US is facing. The personal debt
ratio in the UK is very high, while the economy is vulnerable to the downturn in
the financial sector. The current account deficit is very high and sterling
could face sharp speculative attacks. Worst of all, given Britain’s exposed
public finances, the Chancellor’s fiscal rules prevent him from using budgetary
expansion to sustain growth. The UK could still avoid a major recession, but a
severe slowdown is unavoidable – the International Monetary Fund says UK growth
will slow to just 1.6% – and it is complacent to assume we are somehow better
placed to cope than the US.

No immunity
Overvalued house prices, high personal debt and growing threats to financial
sector balance sheets are equally critical risks for economies outside the US.
Many European banks’ balance sheets hold ­securities backed by US sub-prime
mortgages. Countries such as Spain, Ireland and the UK, where overvalued
domestic house prices are expected to fall, or are already falling, are most
vulnerable to housing downturns and hard landings.

The US situation will have adverse global effects. Japan and China would
suffer from shrinking net exports to the US and it is clear Europe and Asia
would be harmed, too. The more extreme outcomes would also accentuate threats of
destructive trade wars.

The world has entered a period where, as in the 1930s, monetary policy may
become ­ineffective even at very low interest rates. But it is inconceivable
that the American political ­system would tolerate another 1930s-style slump. A
‘Japanese’ scenario is also very unlikely.

The US would go to extreme lengths and use the most radical methods to avoid
a slump or ­prolonged stagnation.

But some potential triggers of a slump or ­stagnation will remain present for
some time. This heightens the danger that some aspects of the extreme scenarios
put forward here will remain plausible. Recession or stagnation are the bigger
near-term threats, but are least likely to be accepted in the medium term.

In contrast, outcomes involving elements of high inflation, sharp dollar
falls and US debt default could have political attractions and are more
plausible in the medium term. A collapsing dollar would force China, Europe and
Japan to accept more of the initial pain of any downturn. But a default scenario
would cause devastating damage to the US’s global position – something the
country cannot afford to let happen.