Five years or more down the road, we’ll look back and wonder why anyone believed that the financial crisis would be brief.
Andy Xie 11 May 2009
New developments are dominating the global economy: A swine flu outbreak threatens the tourism industry, which makes up one-tenth of the global economy; a Chapter 11 bankruptcy filing by Chrysler casts uncertainty over the global auto industry – 4 percent of the global economy; and delayed “stress test” results from U.S. banks raise suspicions that many banks may be insolvent.
These three industries in the news represent about one-fifth of the global economy.
Meanwhile, policymakers continue to speak of “stabilization signs” and “green shoots.” Japan announced another stimulus package, and bank lending in China is soaring. Positive rhetoric by policymakers and the anticipation of effects to come from past stimuli – and the possibilities for further stimuli – have boosted financial markets substantially. The global equity market (MSCI World Index) was up 26 percent by May 1 from its March low, although it’s still only half the November 2007 peak.
Flow data suggests the global economy is bottoming. Retail sales in the United States are probably stabilizing after declining nearly 10 percent. Japan and Britain are probably picking up sequentially from the first quarter. Trade data suggest the precipitous drop-off seen in the last quarter 2008 and first quarter 2009 is coming to an end. Global trade is probably stabilizing at a level one-fifth below the peak reached in the first half 2008.
I predicted several times in this column that the last quarter 2008 and the first quarter 2009 would see a global hard landing, that stability would return in the second quarter 2009, and that the global economy would see a stimulus-inspired bounce in the second half 2009. However, I also believe the economic difficulties will last for years, and that the global economy may dip again in 2010.
The stability we are seeing now is mainly due to liquidity support for corporate and household balance sheets. The burst of the property-cum-credit bubble severely damaged credit worthiness among businesses and households. As the market refuses to roll over these debts, many have had to sell assets to repay loans. Of course when everyone wants to sell, prices are extremely low, potentially bankrupting everyone. Central banks and governments have replaced the market by rolling over debt.
Without immediate pressure to pay off debt, businesses and households are under no pressure to change their habits. This implies that the current stability is based on government support. When this support is removed, problems will return.
Many would argue that, once the economy grows, the problems that businesses and households face will vanish under a rising tide. For example, they say, improved earnings will make businesses more credit-worthy. Markets will be willing to roll over debt. Household income improves in a rising economy, which boosts property demand and property prices. Rising property prices improve home loan quality and decrease borrowing. Essentially, we could grow out of the existing problems.
The “stimulate and grow out of our problems” strategy that everyone seems to be pursuing will not work. It may lead to rampant inflation, currency collapse and political instability. Current economic difficulties are structural in nature, and follow in the wake of a global bubble that severely distorted supply, demand and income distribution. The bubble’s burst exposed the fact that all the pieces of the global economy don’t fit.
Liquidity is the glue that’s holding the pieces together – for now. Unfortunately, glue wears off over time. It’s merely postponing an inevitable adjustment.
Take the auto industry as an example. At first glance, it seems distant from the property-cum-credit bubble. But the industry was actually part of the bubble. On the supply side, the auto industry suffered from overcapacity for years. Why didn’t it adjust earlier? Cheap credit let everyone maintain excess capacity. Furthermore, financial businesses such as GMAC were used to subsidize auto business operations. Of course, the financial arms of the automakers were part of the credit bubble. On the demand side, cheap credit encouraged buyers to change cars frequently. Zero down payment, zero interest rate financing vastly exaggerated auto demand. Now, global vehicle sales may fall below 55 million in 2009 from the peak of 62 million in 2007. Even when the global economy stabilizes, sales won’t climb back to 62 million.
Current global auto sales are below the 2004 level. But since that year, the industry has increased annual production capacity by nearly 20 million units. Now, the global auto industry needs to shrink by one-fourth at least. But the industry is talking about growth opportunities such as electric cars, and demanding government subsidies. Mark my words: The electric car is a concept that will waste massive amounts of taxpayer money. Every time the auto industry is in trouble, it talks about new products. That’s how it sucks in money to stay alive.
The hybrid car is a mature technology that reduces fuel use by one-third or more and can survive in the market without government subsidies. This technology is good for the next five years. Why is there a push for government subsidies to produce electric cars that can’t travel far without recharging, and for which the charging infrastructure doesn’t exist? The electric car may be commercially viable in a decade; the market will find the right technology and the right balance. If government wants to help, it should pump research and development money into research centers, not subsidize the production and purchasing of unviable products.
Chrysler’s bankruptcy won’t solve the industry’s problem. The U.S. government intends to use the process to force the company’s creditors to accept an 80 percent write-down on their debt holdings. After wiping out shareholders 100 percent and debt holders 80 percent, the company seems able to survive. However, it will survive because of capital subsidies, which puts pressure on other producers that have the same financial burden. It starts a vicious cycle that forces other automakers down the same path.
The bottom line is that the global overcapacity is equal to U.S. sales times two. Supply and demand are roughly balanced if two of the three U.S. automakers shut down for good, neither restructured nor revitalized. However, it doesn’t look like that will happen. The political process seems to be wiping out shareholders and bondholders first, and using taxpayer money next to keep an over-bloated industry alive. The industry will destroy capital for years. When governments subsidize electric cars, more money will be wasted. If you invest in the auto industry, you will likely lose.
In a desperate effort to boost auto demand, car owners in Europe and the United States are being offered incentives to buy new and junk the old. This is just advancing future demand. It reduces pressure for the auto industry to restructure and extends the problem over time. The auto industry is an example that current economic difficulties can’t be overcome by stimuli, and governments are not yet on the right path.
Transactions in the secondary property market have picked up recently in China, the United States and many other economies. Many pundits interpret the data as signs of a market recovery. Property is at the center of the current crisis. If it is recovering, the global economy is surely to follow. I think this interpretation is wrong. The pickup in transaction volume is a response to price decline, which is adjustment, not recovery. When a property bubble bursts, it tends to be a protracted affair. After a significant price decline, some buyers who couldn’t afford property before can get into the game. After such buyers are exhausted, the market declines again to attract potential buyers further down the price curve. The process ends until the market drops at or below historical average ratio of price to income. I believe the property market will bottom earliest in late 2010, and may do so in 2012.
Retail sales seem to be stabilizing in all major economies. This may be temporary, and certainly doesn’t presage a significant recovery. After a bubble bursts, people cut back and adjust downward their expenditure levels. But the defense of a lifestyle is a powerful force; the cutback may not be sufficient. When people realize how much poorer they have become, they may have to cut again. Unemployment rates are still rising around the world, which is a headwind to consumption. Wealth and income developments will remain negative for consumption through 2009, and probably through 2010.
My interpretation of the current situation is the same as I forecast at the beginning of the year. The global economy is stabilizing in the second quarter at about 3 percent below the 2008 average and probably 6 percent below the peak level reached in the second quarter 2008. The economic collapse in the past three quarters is certainly the biggest since the 1930s.
The second half of 2009 could see a stimulus-inspired bounce that may see the global economy rise 2 percent or so. Neither the current stability nor the bounce in the second half would signal the return of good growth. The global economy may see a second dip in 2010 and sluggish growth for several years afterward. The reasons are that supply and demand in the real economy are not matched, and that the European and the U.S. governments are dragging their feet on recapitalizing their banks.
I discussed the sorry state of the auto industry above. Far more serious is what’s going on in the financial system. The odds are that losses which are still undisclosed, or have yet to occur at European and the U.S. banks, exceed equity capital. These banks are technically bankrupt but survive on government debt guarantees. If a bank can borrow, it doesn’t have to fold shop even when it doesn’t have any capital. However, such banks can’t function normally, lending to all credit-worthy borrowers. Instead, they are likely to maximize interest spreads to recapitalize themselves. This “earn your way back” scenario is exactly what European and U.S. policymakers are hoping for.
Even if this strategy works, it will take a long time. If banks earn 15 percent annual return on their capital, which is a very optimistic scenario in a poor economic environment, it would take banks more than five years to recapitalize. If the losses are twice as much, which is conceivable, it would take 10 years. Until then, banks will not lend normally. And the global economy will stagnate for that long.
Economic stagnation could have nasty social and political consequences. Europe, for example, seems unstable. Its unemployment rates are heading back to double-digits, where they were a decade ago. Its unemployed youth are in a rebellious mood. Its aging population problem is far worse now. Baby boomers who are retiring are desperate to hang on to their expected benefits. They will react violently to any cutbacks in pensions and other benefits. But all European governments suffer from unsustainable fiscal deficits. They will have to raise taxes or cut benefits. If they do the former, their economies will deteriorate further, and unemployment may surge to levels that endanger social stability. If they do the latter, baby boomers may rebel. Europe is a mess for the foreseeable future.
The ratio of U.S. household debt to income needs to fall by one-third or more. Saving more is the right thing to do. But it keeps consumption down. It will take at least five years for the U.S. household sector to bring debt levels down to the historical mean, which means a sluggish U.S. economy for five years.
Many investors, if not most, refuse to accept that the global economy will take a long time to heal. They hang their hopes on government stimulus and its potential to bring on another asset bubble. The theory that says “get the stock market up and everything else will follow” is very popular among institutional and retail investors. Such sentiments can make the stock market rise for a period of time. But, ultimately, it will fail. The hoped-for improvements in fundamentals won’t materialize.
As governments and central banks around the world try to resolve structural problems with stimuli, the global economy is probably heading toward stagflation. Despite exceptionally weak demand, oil prices have been rising. The current price of more than US$50 a barrel cannot be justified by supply and demand. Rather, prices are being driven by the withholding of financial supply and demand. Money has been flooding into exchange traded funds that buy oil futures. Oil exporting countries are cutting production; they think it’s better to keep oil in the ground than exchange it for paper currencies that could devalue precipitously. Rising prices for oil and other commodities, driven by inflation expectations, could trigger inflation in 2010 despite a sluggish global economy. We could be witnessing a replay of the 1970s.
1 comment:
Stimulate Away Our Imbalances? Dream On
Five years or more down the road, we’ll look back and wonder why anyone believed that the financial crisis would be brief.
Andy Xie
11 May 2009
New developments are dominating the global economy: A swine flu outbreak threatens the tourism industry, which makes up one-tenth of the global economy; a Chapter 11 bankruptcy filing by Chrysler casts uncertainty over the global auto industry – 4 percent of the global economy; and delayed “stress test” results from U.S. banks raise suspicions that many banks may be insolvent.
These three industries in the news represent about one-fifth of the global economy.
Meanwhile, policymakers continue to speak of “stabilization signs” and “green shoots.” Japan announced another stimulus package, and bank lending in China is soaring. Positive rhetoric by policymakers and the anticipation of effects to come from past stimuli – and the possibilities for further stimuli – have boosted financial markets substantially. The global equity market (MSCI World Index) was up 26 percent by May 1 from its March low, although it’s still only half the November 2007 peak.
Flow data suggests the global economy is bottoming. Retail sales in the United States are probably stabilizing after declining nearly 10 percent. Japan and Britain are probably picking up sequentially from the first quarter. Trade data suggest the precipitous drop-off seen in the last quarter 2008 and first quarter 2009 is coming to an end. Global trade is probably stabilizing at a level one-fifth below the peak reached in the first half 2008.
I predicted several times in this column that the last quarter 2008 and the first quarter 2009 would see a global hard landing, that stability would return in the second quarter 2009, and that the global economy would see a stimulus-inspired bounce in the second half 2009. However, I also believe the economic difficulties will last for years, and that the global economy may dip again in 2010.
The stability we are seeing now is mainly due to liquidity support for corporate and household balance sheets. The burst of the property-cum-credit bubble severely damaged credit worthiness among businesses and households. As the market refuses to roll over these debts, many have had to sell assets to repay loans. Of course when everyone wants to sell, prices are extremely low, potentially bankrupting everyone. Central banks and governments have replaced the market by rolling over debt.
Without immediate pressure to pay off debt, businesses and households are under no pressure to change their habits. This implies that the current stability is based on government support. When this support is removed, problems will return.
Many would argue that, once the economy grows, the problems that businesses and households face will vanish under a rising tide. For example, they say, improved earnings will make businesses more credit-worthy. Markets will be willing to roll over debt. Household income improves in a rising economy, which boosts property demand and property prices. Rising property prices improve home loan quality and decrease borrowing. Essentially, we could grow out of the existing problems.
The “stimulate and grow out of our problems” strategy that everyone seems to be pursuing will not work. It may lead to rampant inflation, currency collapse and political instability. Current economic difficulties are structural in nature, and follow in the wake of a global bubble that severely distorted supply, demand and income distribution. The bubble’s burst exposed the fact that all the pieces of the global economy don’t fit.
Liquidity is the glue that’s holding the pieces together – for now. Unfortunately, glue wears off over time. It’s merely postponing an inevitable adjustment.
Take the auto industry as an example. At first glance, it seems distant from the property-cum-credit bubble. But the industry was actually part of the bubble. On the supply side, the auto industry suffered from overcapacity for years. Why didn’t it adjust earlier? Cheap credit let everyone maintain excess capacity. Furthermore, financial businesses such as GMAC were used to subsidize auto business operations. Of course, the financial arms of the automakers were part of the credit bubble. On the demand side, cheap credit encouraged buyers to change cars frequently. Zero down payment, zero interest rate financing vastly exaggerated auto demand. Now, global vehicle sales may fall below 55 million in 2009 from the peak of 62 million in 2007. Even when the global economy stabilizes, sales won’t climb back to 62 million.
Current global auto sales are below the 2004 level. But since that year, the industry has increased annual production capacity by nearly 20 million units. Now, the global auto industry needs to shrink by one-fourth at least. But the industry is talking about growth opportunities such as electric cars, and demanding government subsidies. Mark my words: The electric car is a concept that will waste massive amounts of taxpayer money. Every time the auto industry is in trouble, it talks about new products. That’s how it sucks in money to stay alive.
The hybrid car is a mature technology that reduces fuel use by one-third or more and can survive in the market without government subsidies. This technology is good for the next five years. Why is there a push for government subsidies to produce electric cars that can’t travel far without recharging, and for which the charging infrastructure doesn’t exist? The electric car may be commercially viable in a decade; the market will find the right technology and the right balance. If government wants to help, it should pump research and development money into research centers, not subsidize the production and purchasing of unviable products.
Chrysler’s bankruptcy won’t solve the industry’s problem. The U.S. government intends to use the process to force the company’s creditors to accept an 80 percent write-down on their debt holdings. After wiping out shareholders 100 percent and debt holders 80 percent, the company seems able to survive. However, it will survive because of capital subsidies, which puts pressure on other producers that have the same financial burden. It starts a vicious cycle that forces other automakers down the same path.
The bottom line is that the global overcapacity is equal to U.S. sales times two. Supply and demand are roughly balanced if two of the three U.S. automakers shut down for good, neither restructured nor revitalized. However, it doesn’t look like that will happen. The political process seems to be wiping out shareholders and bondholders first, and using taxpayer money next to keep an over-bloated industry alive. The industry will destroy capital for years. When governments subsidize electric cars, more money will be wasted. If you invest in the auto industry, you will likely lose.
In a desperate effort to boost auto demand, car owners in Europe and the United States are being offered incentives to buy new and junk the old. This is just advancing future demand. It reduces pressure for the auto industry to restructure and extends the problem over time. The auto industry is an example that current economic difficulties can’t be overcome by stimuli, and governments are not yet on the right path.
Transactions in the secondary property market have picked up recently in China, the United States and many other economies. Many pundits interpret the data as signs of a market recovery. Property is at the center of the current crisis. If it is recovering, the global economy is surely to follow. I think this interpretation is wrong. The pickup in transaction volume is a response to price decline, which is adjustment, not recovery. When a property bubble bursts, it tends to be a protracted affair. After a significant price decline, some buyers who couldn’t afford property before can get into the game. After such buyers are exhausted, the market declines again to attract potential buyers further down the price curve. The process ends until the market drops at or below historical average ratio of price to income. I believe the property market will bottom earliest in late 2010, and may do so in 2012.
Retail sales seem to be stabilizing in all major economies. This may be temporary, and certainly doesn’t presage a significant recovery. After a bubble bursts, people cut back and adjust downward their expenditure levels. But the defense of a lifestyle is a powerful force; the cutback may not be sufficient. When people realize how much poorer they have become, they may have to cut again. Unemployment rates are still rising around the world, which is a headwind to consumption. Wealth and income developments will remain negative for consumption through 2009, and probably through 2010.
My interpretation of the current situation is the same as I forecast at the beginning of the year. The global economy is stabilizing in the second quarter at about 3 percent below the 2008 average and probably 6 percent below the peak level reached in the second quarter 2008. The economic collapse in the past three quarters is certainly the biggest since the 1930s.
The second half of 2009 could see a stimulus-inspired bounce that may see the global economy rise 2 percent or so. Neither the current stability nor the bounce in the second half would signal the return of good growth. The global economy may see a second dip in 2010 and sluggish growth for several years afterward. The reasons are that supply and demand in the real economy are not matched, and that the European and the U.S. governments are dragging their feet on recapitalizing their banks.
I discussed the sorry state of the auto industry above. Far more serious is what’s going on in the financial system. The odds are that losses which are still undisclosed, or have yet to occur at European and the U.S. banks, exceed equity capital. These banks are technically bankrupt but survive on government debt guarantees. If a bank can borrow, it doesn’t have to fold shop even when it doesn’t have any capital. However, such banks can’t function normally, lending to all credit-worthy borrowers. Instead, they are likely to maximize interest spreads to recapitalize themselves. This “earn your way back” scenario is exactly what European and U.S. policymakers are hoping for.
Even if this strategy works, it will take a long time. If banks earn 15 percent annual return on their capital, which is a very optimistic scenario in a poor economic environment, it would take banks more than five years to recapitalize. If the losses are twice as much, which is conceivable, it would take 10 years. Until then, banks will not lend normally. And the global economy will stagnate for that long.
Economic stagnation could have nasty social and political consequences. Europe, for example, seems unstable. Its unemployment rates are heading back to double-digits, where they were a decade ago. Its unemployed youth are in a rebellious mood. Its aging population problem is far worse now. Baby boomers who are retiring are desperate to hang on to their expected benefits. They will react violently to any cutbacks in pensions and other benefits. But all European governments suffer from unsustainable fiscal deficits. They will have to raise taxes or cut benefits. If they do the former, their economies will deteriorate further, and unemployment may surge to levels that endanger social stability. If they do the latter, baby boomers may rebel. Europe is a mess for the foreseeable future.
The ratio of U.S. household debt to income needs to fall by one-third or more. Saving more is the right thing to do. But it keeps consumption down. It will take at least five years for the U.S. household sector to bring debt levels down to the historical mean, which means a sluggish U.S. economy for five years.
Many investors, if not most, refuse to accept that the global economy will take a long time to heal. They hang their hopes on government stimulus and its potential to bring on another asset bubble. The theory that says “get the stock market up and everything else will follow” is very popular among institutional and retail investors. Such sentiments can make the stock market rise for a period of time. But, ultimately, it will fail. The hoped-for improvements in fundamentals won’t materialize.
As governments and central banks around the world try to resolve structural problems with stimuli, the global economy is probably heading toward stagflation. Despite exceptionally weak demand, oil prices have been rising. The current price of more than US$50 a barrel cannot be justified by supply and demand. Rather, prices are being driven by the withholding of financial supply and demand. Money has been flooding into exchange traded funds that buy oil futures. Oil exporting countries are cutting production; they think it’s better to keep oil in the ground than exchange it for paper currencies that could devalue precipitously. Rising prices for oil and other commodities, driven by inflation expectations, could trigger inflation in 2010 despite a sluggish global economy. We could be witnessing a replay of the 1970s.
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