This is to react to a comment made by one of France’s most popular econ-bloggers, on my previous post. First: thanks, Alexandre! I wanted to react with a just few words to your comment, but then one topic led me into the other… This led me to think that I gathered material for a proper post, and since I enjoy spending my time on random activities like blogging on some week-ends, then why not just go ahead…? It must also be noted that my previous post was born out of a pure, quasi-sentimental, concern for the UK economy on a Saturday morning lingering around at home and listening to BBC radio online. I happened to live in the UK for a few years until a few months ago. The post was not the result of concern for the global, European and other fallout of the Credit Crunch, which I was determined to leave to specialists.
Yet the ramifications of this Thing Called the Crunch, are enormous. What implications for the unwinding of global financial imbalances, and even the status of the United States in the World? What implications for the stock markets – with their turbulences all over this week? Can Central Banks cope? What is now the place of structured finance in global financial markets? How should regulatory systems respond, adapt, and be reformed to make sure such a thing never happens again? What can the IMF do? And: Who else will be hit? Etc etc…. So Alexandre Delaigue pointed to the question of “who else will be hit”? As said earlier, it doesn’t look like emerging markets or countries like Germany risk being hit too strongly. One never knows, however, especially given how equity markets have been in jitters this week as a consequence of recent economic turmoil.
Alexandre Delaigue put his bet on Spain and Ireland, pointing to the role and share of the housing market in the economic boom both countries have been witnessing. Economists and markets, before the crisis, were already concerned with risks of the real-estate boom-or-bubble in Spain and Ireland. A slowdown was expected before the sub-prime fallout anyway (some form of bust was also expected in the US too). Here a good article written in The Banker [free but registration needed] for their July edition last year on Spain’s economy. Signs of actual slowdown in Spain are here already, the government has been taking issue with it. The question is not whether these economies will slow down after more than a decade of economic catch-up and boom, but when, and whether the landing will be soft or hard. Will the sub-prime crisis be the trigger, and make matters worse? Must there be a banking crisis, like that in the US or the UK, with the Northern Rock embarrassment? The question is also that of how contagion will operate. Will there be a blind wildfire of credit crunches, or will financial institutions be able and willing to discriminate between the situation in Spain (Housing boom/bubble yes, but not much subprime lending), Ireland (haven’t been able to quickly find info on the matter, but Ireland is indeed very much exposed to a slow-down in the US economy), or the UK? So, yes, some countries in Europe are certainly more exposed than others to such risk and to contagion of the bubble, but how and when remains an open question.
On the other questions regarding the credit crunch issue.
- Consequences for US standing in the world: George Soros’ views this week in the FT I found quite amusing. It adds spice to the current drama.
- On stock markets: I leave the reader with his/her newspapers
- On Central Banks: the stock market jitters this week show lots of uncertainty around the issue. Wait and see.
- Structured finance and its future in the global financial system. While I was working with the specialist magazines at FT Business in 2006-2007, structured finance was The Big Thing journalists wanted to cover. One issue I realized is how much asset-backed securities, CDOs etc allowed for new risks to be taken: accelerate the diffusion of car loans or mortgages in Russia (we even dedicated a session to AMBS in Russia at a few of our conferences) or lend to poorer US-Americans who would never have had access to a normal mortgage. These products are a very clever way of spreading risk, thus allowing banks and investors to take on more risks and create new forms of business. The issue, however, is transparency: Where is the risk? Where are the losses? Here an excellent article by Jacques de Larosière in The Banker on the matter of transparency in the current crisis.
- Now, then, to regulation. The debate is full on. What should be done and who should to what? Too long a discussion (I recommend the FT’s coverage of Davos – lots being said right now. The Wall Street Journal is also a good reference on those matters). To me, two questions were raised by the subprime crisis and the Northern Rock debacle. First: regulating structured products themselves. They obviously need to enter the fold of official regulation. The were born outside it. The challenge is to raise transparency and accountability. But how not to kill the goose that lays the golden eggs by overburdening, over-prescribing, or raising costs excessively? The second issue raised is a classic issue of how to solve a banking crisis. And here let me simply quote from a World Bank research paper written in 1997, and that is as up-to-date as ever in the debate on the rescue of Northern Rock:
“banking crises disrupt the flow of credit to households and enterprises, reducing investment and consumption and possibly forcing viable firms into bankruptcy. Banking crises may also jeopardize the functioning of the payments system and, by undermining confidence in domestic financial institutions, they may cause a decline in domestic savings and/or a large scale capital outflow. Finally, a systemic crisis may force sound banks to close their doors1. In most countries policy-makers have attempted to shore up the consequences of banking crises through various types of intervention, ranging from the pursuit of a loose monetary policy to the bail out insolvent financial institutions with public funds. Even when they are carefully designed, however, rescue operations have several drawbacks: they are often very costly for the budget; they may allow inefficient banks to remain in business; they are likely to create the expectation of future bail-outs reducing incentives for adequate risk management by banks; managerial incentives are also weakened when — as it is often the case — rescue operations force healthy banks to bear the losses of ailing institutions. Finally, loose monetary policy to shore up banking sector losses can be inflationary and, in countries with an exchange rate commitment, it may trigger a speculative attack against the currency. “