Nikkei Veritas – Market Eye column, 23rd April 2008
Alan Greenspan, who was then Chairman of the Federal Reserve, expressed concern about the stock market in 1996, which he thought showed signs of “irrational exuberance”. Unfortunately he then changed from critic to cheerleader and he and his successor, Dr Bernanke, have since argued that central bankers should not be concerned with asset prices. Stephen Wright and I wrote an article in World Economics in 2002, criticising this view. We thought it was misguided then and I am confident that there are few people who would disagree with our view today.
Since 1996, the surge in asset prices, which has included houses, commercial property, loans and shares, was both made possible and in turn encouraged a dramatic rise in bank lending and other forms of debt. The world is now threatened by an equally dramatic cut-back. As asset prices fall, banks have had to write-off large amounts of their equity capital, and also see the apparent risks of new lending rise. They are thus both less able and less willing to extend credit than they were.
During the past decade there has not only been a rapid rise in bank lending, but also a massive expansion of credit which has been financed outside the banking system. Hedge funds and others have borrowed very large amounts of money to buy packages of debt. This was often financed without direct borrowing from banks by issuing commercial paper. As the value of these debt packages, such as CDOs and CLOs, has fallen, the hedge funds have made large losses. They are now less able to raise money from investors and less willing to borrow heavily. In place of rapid growth, the availability of credit outside the banking system is shrinking. In order to prevent this causing a major reduction in total credit, the banking system needs to expand its credit creation even more rapidly and it neither has the capital, nor the willingness to do this.
A change from the rapid expansion of credit to slow growth, or possibly even contraction, is likely to be associated with further falls in asset prices. While asset prices were rising, savings appeared to be unnecessary and, in the US and UK, households virtually stopped saving altogether. In much of the rest of the world, however, savings remained high and the disparity caused large savings’ flows between different countries, which were reflected in massive current account deficits.
The willingness of the Federal Reserve to allow the explosion of debt has thus permitted the emergence of major disequilibria in the world economy. Some commentators have emphasised the problem of asset prices, others the collapse of household savings in Anglophone economies and others the expansion of current account deficits. All these are connected and all are symptoms of excessive monetary ease, for which the Federal Reserve must take the main blame.
But the past cannot be undone. Tightening credit today will not compensate for the excesses of yesterday, but rather make matters worse. The Federal Reserve has therefore cut interest rates at a fast pace and will, I assume, continue to do so. Together with other central banks, the US Treasury and Finance Ministries everywhere, efforts are being made to prevent the development of a major recession, without raising worries about future inflation.
Economic forecasts are notoriously unreliable and are particularly likely to be so under current circumstances, for which the past offers so little guide. The likely course of events can, however, be divided into three main possibilities. The first is that we may have a major recession, despite the efforts of central banks. The second is that economic recovery will be accompanied by rising concern about inflation. The third is that we suffer a fairly prolonged period of slow growth, during which inflation subsides.
The evils of a major recession are obvious, but even those of too rapid recovery are considerable. The Fed would have to raise interest rates quickly to dampen the rise in inflationary expectations and the US would soon be threatened again with that combination of inflation and poor growth which is known as stagflation.
A fairly prolonged period of weak growth is probably the best prospect, but none of the likely outturns will be welcomed.