In today’s Financial Times, former U.S. Federal Reserve chairman Alan Greenspan has taken the unusual step of playing market pundit even while his successor struggles to deal with the mighty financial turmoil he engendered. It is highly unusual to see an ex Central Bank head talking about market turmoil and contrasting it negatively to periods during his reign, but Greenspan does this.
At first blush, his commentary seems meant to merely warn of potential heavy-handed government responses to the crisis. However, in my view, this piece solidifies Greenspan as a purely political animal looking to shore up his weakening legacy.
Greenspan warns of more bank bail-outs
The surprise of recent months is not that global economic growth is slowing, but that there is any growth at all. The credit crunch of the past year has not followed the path of recent economically debilitating episodes characterised by a temporary freezing up of liquidity – 1982, 1989, 1997-8 come to mind. This crisis is different – a once or twice a century event deeply rooted in fears of insolvency of major financial institutions.
This crisis was not brought to closure by the world’s central banks’ injection of huge doses of short-term liquidity. Only when sovereign credits were substituted for private bank credit, first in the case of the UK (Northern Rock) and subsequently in the case of the U.S. (Bear Stearns), was a semblance of stability restored to markets. But the London Interbank Offered Rate spreads on overnight index swaps and credit default swaps of financial institutions have not returned to the modest pre-crisis levels. Fears of insolvency have not, as yet, been fully set aside. There may be numbers of banks and other financial institutions that, at the edge of defaulting, will end up being bailed out by governments.
The insolvency crisis will come to an end only as home prices in the U.S. begin to stabilise and clarify the level of equity in homes, the ultimate collateral support for much of the financial world’s mortgage-backed securities. However, U.S. home prices will stabilise only when the absorption of the huge excess of single-family vacant homes that emerged as the U.S. housing boom peaked in 2006 is much further advanced than it is now. New single-family home completions are currently barely under the rate of home demand generated by household formation and replacement needs. Only later this year will the current suppressed level of housing starts be reflected in completion levels consistent with a rapid rate of liquidation of the inventory glut, and this, of course, assumes that current levels of demand for housing hold up.
Pending that outcome, the price of equities worldwide will determine whether the international financial system can maintain a modicum of stability as it eases out of its credit crunch, or falls back into another period of angst and turmoil.
The optimistic case rests on the business world beyond finance. Given this past year’s vast impairment of financial intermediation, nonfinancial corporate business has held up surprisingly well, contributing to a flow of corporate earnings that has helped sustain a stressed global stock market. To be sure, global stock prices are off a fifth from their October 2007 peaks, but still hover at levels last seen in 2006, a demonstrably less fear-ridden period than currently prevails.
A sustained level of global equity prices will be critical if banks are to recapitalise themselves at the higher levels daunted investors now require. The pool of capital is being augmented by a reasonably high level of saving (nearly 24 per cent of world gross domestic product), up significantly from earlier this decade. The flow of new saving will provide some support.
Capital gains, however, are just as important. This can best be observed in the context of the consolidated balance sheet of the world economy. All debt and derivative claims offset in global accounting, leaving real physical and intellectual assets and their market value reflected as net worth. Capital gains cannot finance new physical investment, but do add to global net worth. If, for whatever reason, discounting of prospective future earnings engendered by the world’s physical capital stock declines, the market value of that capital stock rises with no offsetting liability. There is accordingly a larger value of equity shoring up the capital of financial or nonfinancial businesses. Should that discount rate reverse, the value of world equity will fall. Consequently, lower global stock prices could impede the recapitalisation of banks and other financial institutions. Debt issuance would also be suppressed as it leverages off the level of equity.
Globalisation is at the root of the past decade’s unprecedented surge in world economic activity. The growth in the volume of global trade has far exceeded the pace of world real GDP growth for decades. Between 2001 and 2007 global cross-border investments (at market values) rose almost two-thirds faster than world nominal GDP, according to data from the International Monetary Fund.
The economic edifice – market capitalism – that has fostered this expansion is now being pilloried for the pause and partial retrenchment. The cause of our economic despair, however, is human nature’s propensity to sway from fear to euphoria and back, a condition that no economic paradigm has proved capable of suppressing without severe hardship. Regulation, the alleged effective solution to today’s crisis, has never been able to eliminate history’s crises.
A financial crisis is heralded, in fact defined, by sharp discontinuities of asset prices. The crisis must thus be unanticipated. The fact that risk was heavily underpriced for much of this decade was broadly recognised in the financial community, but the timing of the sharp price correction was nonetheless a surprise.
Recent history is replete with such underpricing persisting for years. Those market players who withdraw from “long” commitments at the first sign of an excess of exuberance, risk losing market share. They thus continue “to dance” as Chuck Prince, the former Citigroup chairman put it, but always assume they will have time to exit the markets. The vast majority invariably fail. When the current crisis emerged, it was assumed that the weak links would be unregulated hedge and private funds. The losses, however, have been predominately in the most heavily regulated institutions – banks.
We may not easily confront or accept the price dynamics of home and equity prices, but we can fend off cries of political despair which counsel the containment of competitive markets. It is essential that we do so. The remarkably strong performance of the world economy since the near universal adoption of market capitalism is testament to the benefits of increasing economic flexibility.
It has become hard for democratic societies accustomed to prosperity to see it as anything other than the result of their deft political management. In reality, the past decade has seen mounting global forces (the international version of Adam Smith’s invisible hand) quietly displacing government control of economic affairs. Since early this decade, central banks have had to cede control of long-term interest rates to global market forces. Previously heavily controlled economies – such as China, Russia and India – have embraced competitive markets in lieu of bureaucratic edict. The danger is that some governments, bedevilled by emerging inflationary forces, will endeavour to reassert their grip on economic
affairs. If that becomes widespread, globalisation could reverse – at awesome cost.The writer is the former chairman of the U.S. Federal Reserve