By Ambrose Evans-Pritchard 08/08/2008
State error led banks to ignore the lessons of history and overdose on too-cheap money, writes Ambrose Evans-Pritchard
Three years ago, the world’s top watchdog warned that the global economy was veering out of control. Defending orthodoxy against the easy debt policies of the Greenspan era, the Bank for International Settlements said interest rates were being held too low for safety in most of the mature economies.
America had embarked on an unprecedented experiment. The US savings rate had fallen to near zero for the first time since the Slump. The current account deficit had reached levels that were incompatible with the dollar’s role as the anchor of the global system.
The rising powers of Asia were preventing adjustment by holding down their currencies, and flooding the world with cheap credit in the process. Incipient bubbles were ubiquitous. “Most industrial countries are showing symptoms of over-heating in the housing market,” it said.
New-fangled securities were allowing banks to take “highly leveraged positions”. It was unclear how these untested inventions would “handle a string of credit blow-ups”.
“One simply cannot ignore the number of indicators that are now simultaneously exhibiting marked deviations,” concluded the BIS. That was in June 2005.
Regrettably, governments did exactly that. They ignored manifest risks. Real interest rates were held near or below zero in the US and a large arc of Europe until well into 2006.
By then, the damage was done. US housing had succumbed to full-fledged mania. Variants were emerging – later in the cycle – across the Anglo-Saxon world, the Baltic, Club Med, and Eastern Europe.
What occurred was a fatal cocktail, a mix of too much and too little government intervention at the same time. Bureaucrats (central banks) held down the price of credit: other bureaucrats (regulators) turned a blind eye to the excesses that cheap money caused in mortgages and the “shadow banking system” – that $3 trillion nexus of structured credit. Northern Rock continued to offer 125pc mortgages. Honey-trap “teaser” loans continued to ensnare Americans.
Former Federal Reserve chief Alan Greenspan now says the world faces a “once or twice in a century event”. Faith in the financial system has been called into question. Taxpayers will have to rescue more banks. Missing is any hint of apology for his role in incubating this crisis as monetary overlord for 20 years.
Where did it all go wrong? One could start by looking at the trajectory of total US debt, up from 130pc to 350pc of GDP since 1982. “We’ve had a 30-year leveraging up of America, ending in an unchecked orgy,” said Charles Dumas, from Lombard Street Research.
“The final straw was the Fed’s hopelessly slow tightening from 2004 onwards. There was no excuse for the interest rates of 1pc, and then they went through this ludicrous metronome dance of quarter-point hikes,” he said.
Mr Dumas said the fuel for the third-stage blast of the US debt rocket came from Asia’s “savings glut”. China, Taiwan, Vietnam and other exporters have built up huge surpluses by holding down their currencies through dollar pegs or “dirty floats”.
Together with Russia and the Mid-East petro-powers, they have accumulated a war chest of some $6 trillion in reserves. This must be recycled into foreign assets. Most went into US and European bonds, pushing down the cost of long-term capital for the entire global system.
On top of this, roughly $250bn a year fled zero-interest rates in Japan to chase better returns abroad through the “carry trade”. Japan’s emergency stimulus leaked everywhere.
The ensuing bond bubble depressed yields for pension funds and insurers obliged to buy “AAA” assets, leaving them struggling to match their long-term liabilities. They were easy prey when the sharks came along with sub-prime debt “sliced and diced” into irresistible blocks of “AAA” securities, promising high yields.
Rules made matters worse. Professor Peter Spencer, from York University, said the Basle code on capital adequacy ratios caused a perverse side-effect. “By making banks raise capital against their balance sheets, it gave them a strong incentive to move off balance sheets,” he said.
The Fed could have done a great deal to offset the tsunami of Asian money by squeezing liquidity at home. It chose not to do so. Mr Greenspan and his protégé, Ben Bernanke, saw no need to act because inflation was tamed.
Cheap Asian goods flooded the world, keeping a lid on inflation in the West. It lulled the central banking fraternity into a false sense of security. As they slept, the excess money found its way into asset booms. This was the “Great Error”.
“Policymakers interpreted the quiescence in inflation to mean that there was no good reason to raise rates when growth accelerated, and no impediment to lowering them when growth faltered,” said the BIS last month.
Nobel laureate Joe Stiglitz said the new “fad” of inflation-targeting had led policymakers astray. The dogma fails to distinguish between different causes of inflation. It should be ditched. “My sympathies go to the unfortunate citizens of those countries that implement inflation targeting,” he said. Britain is one of them. So are Australia, New Zealand, Sweden, and Iceland. All have property bubbles.
Mr Greenspan argued that it was not for central banks to steer asset prices. In reality, he slashed rates to rescue banks during the Russian default/LTCM crisis in 1998. He slashed them even further after the dotcom bust. Yet he always let speculative booms run their course.
This was the “Greenspan Put”. Markets believed they could count on welfare for Wall Street in the end. The culture of moral hazard degenerated by degrees, culminating in a near-total disregard for risk by 2007.
The liquidation purge needed at the end of every cycle was cut short, leaving the toxins in the system. Each upswing was built on more deformed foundations. An addiction to low real interest insidiously drew down prosperity from the future – “intertemporal misallocation” in BIS lingo. The future finally arrived in 2007.
The Greenspan-Bernanke assumption was that the Fed could “clean up” after bubbles had burst. This was a risky view in light of what followed the US bubble in the 1920s and Japan’s Nikkei bubble in the 1980s. It derives from the Milton Friedman doctrine that the slumps can always be avoided by monetary stimulus à l’outrance (to the utmost). If only life were so simple.
The Fed clearly had no inkling of the shock that was about to hit them last year. Mr Bernanke said on June 5 that ” the troubles in the sub-prime sector seem unlikely to spill over to the broader economy or the financial system”. Losses would be $50bn to $100bn. (The IMF now says nearly $1,000bn).
At the Fed’s early August meeting, it issued a hawkish statement, seemingly unaware that Countrywide – America’s top mortgage underwriter – had just warned house price falls were reaching “levels not seen since the Great Depression”. Markets took matters into their own hands.
“The Fed was in this mental state [that] it was just a short-term problem,” said Jim O’Neill, global strategist at Goldman Sachs. “Their biggest mistake was that they failed to realise how far the real estate market would fall.”
Mr Bernanke has been playing catch-up ever since. He rushed through the most dramatic set of rates cuts in Fed history. He invoked Article 13 (3) of its charter, the Depression-era clause allowing it to take on direct liabilities, starting with $30bn of Bear Stearns debt. The US government bailed out Fannie Mae and Freddie Mac. This is a de facto nationalisation of the world’s two biggest financial institutions.
Critics say the rescues have failed. One can only ask what would have happened if nothing had been done. There is no “solution” to this crisis. The task now is to keep the ship afloat as debt defaults run their awful course.
It will be a long work-out. Japan has suffered its Lost Decade, with the worst pain in the second half. Don’t assume the Anglo-Saxons and Club Med will get off more lightly. Japan started its descent as top creditor, brimming with reserves and savings. Westerners go down empty.
Henceforth, we must design out asset bubbles. The BIS suggests a credit speed limit of sorts. Old-fashioned monetarists say the debacle could have been avoided if we had paid more heed to the M3 and M4 money supply. These aggregates blew the whistle three years ago.
At root, this crisis was caused by state error. Governments and economic ideologies rigged the system in favour of debt. City and Wall Street banks were pushed into behaving with reckless abandon. They took part shamelessly, of course. But their antics were merely symptoms of a deeper problem.
Needless to say, this is not the perception in North America or Europe. It already looks as if the political response will be a massive assault on the workings of the free market. Socialism is coming back. One wants to weep.