[DEBATE] : Brace for Act II when crisis goes global - FT column
Riaz K. Tayob
riazt at iafrica.com
Thu Sep 20 22:57:26 BST 2007
Brace for Act II when the crisis goes global By Wolfgang Munchau
There has been some good news in the past week and a lot more bad news.
The good news consisted of tentative signs that the credit markets were
stabilising. Conditions in the asset-backed commercial paper market also
appeared to improve. The bad news was the shocking bail-out of Northern
Rock, a UK mortgage bank. I would nevertheless suspect that within a few
months, the banking sector will have absorbed most of the horrible real
estate investments and the financial markets will be celebrating an end
to the crisis.
Unfortunately, I fear this is only going to be the end of Act I. Act II
plays out in the real world. Act II begins with a sharp slowdown in US
economic growth. The two obvious questions that arise from this scenario
are: how bad will the US downturn be and how contagious will it be?
It looks as though it will be bad. Some optimists had hoped that the
rest of the world could easily withstand a US recession and invented the
infamous de-coupling theory. What they did not count on was the rapid
decline of the US currency as expectations of a US recession were
rising. A weak dollar is going to be the main global transmission
Against the euro, the dollar last week recorded its lowest value since
the start of European economic and monetary union in 1999. Forecasting
exchange rates is an inherently dangerous game. Some market observers
are now preparing for the bilateral exchange rate to move into the
$1.40-$1.45 range. While the euro area has been able to withstand the
appreciation of the euro without damage ? and with surprisingly little
noise from Paris ? I would expect both of these benign factors to
disappear suddenly once the euro breaks through $1.40. There is nothing
magic about this particular number, but it will serve as an excuse for
Short spikes in an exchange rate do not have much economic effect, but
if the exchange rate were to remain in the $1.40-$1.45 trading range for
a long period, it would no doubt affect eurozone exports and growth. Add
to this the more direct effects of the credit crisis plus the global
cyclical slowdown that has already started and you have the ingredients
for a sharp downturn. If the US economy tanks, the rest of the world
will follow with some delay. Act II of the crisis is therefore the
transmission from the US to the global economy.
One could also look at this in another way. There are two independent
crises playing out in successive fashion. One is the crisis of the
securitised financial markets. The other is the crisis of global
imbalances, a micro and a macro event respectively.
The debate about global imbalances, which raged in the years 2004 and
2005, may have died down, but the problems have not been resolved. ?If
something cannot go on forever, it will stop,? Herb Stein, economic
adviser to former US President Richard Nixon, once famously remarked.
This is what Act II is all about.
It is worth revisiting an important paper on this subject, written in
2004 by the economists Maurice Obstfeld and Kenneth Rogoff*, in which
they construct a model that shows in detail how global imbalances are
likely to unwind. They argue that the process would begin with a sudden
shock ? they presciently envisaged a US recession brought about by a
fall in house prices. As part of this process the value of the dollar
would fall significantly.
The mechanism described in this paper bears an uncanny resemblance to
the events we have already witnessed in Act I of our drama. The good
news is that the certain fall in US interest rates, combined with a fall
in the dollar, will eventually do the trick. The bad news is that this
might take a lot longer than in 2001. The Fed will cut interest rates,
but not by nearly as much as it did then. In Europe, the European
Central Bank had even planned to raise interest rates, and some central
bankers are still pretending as though this was still the case.
I would expect cries of ?too little, too late? to dominate the monetary
policy debate during Act II, as contagion spreads from the US to the
rest of the world.
By the end of Act II, there is a reasonable chance that global
imbalances will have unwound. US imports will have fallen. Exports will
rise, as will the savings rate.
Will there be an Act III? Quite possibly. Moody?s, the rating agency,
has predicted that a US recession could see a rise in corporate default
rates from 1.4 per cent of rated companies last year to about
12 per cent ? a level last seen during the early 1990s and after the
dotcom crash. When that happens, it will be interesting to see how the
credit markets will cope. Many investors have over-optimistically agreed
to sell insurance against corporate defaults through credit default
swaps, a market that has grown exponentially in the last few years. This
raises a number of questions: how many of these guarantees will have to
be invoked, how much of this will be actually paid, and what happens if
investors default en masse?
The subprime glitch may soon be over. But the credit and global
adjustment crises have only just begun.
*The Unsustainable US Current Account Position Revisited, NBER Working
Paper No. 10869, 2004
Copyright The Financial Times Limited 2007
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