By Michael Baxter 15 Jan 2010 [1 Comment | 1,130 views]
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Oh deary, deary. One of the most eagerly anticipated of all economic publications, the annual Global Risk Report, from the World Economic Forum, has warned that the risk of a new meltdown in financial services has not gone away. The next year or two could see another financial crisis, maybe an even more serious one than the banking crisis we are now recovering from. Should we run for the hills?
The last ten years or so has seen no shortage of crises. There was the Asian crisis of 1997, followed by the Russian crisis of 1998. In both cases Western credit had funded a boom. Initially the boom was built on rising productivity, but then it got silly, it became completely unsustainable, and then…crash.
In the wake of the Russian crisis, Long Term Capital Management (LTCM) went pear shaped, and for a while it seemed as if the global banking system was set to go into meltdown. It was in the midst of this crisis that Alan Greenspan earned his spurs. He made a phone call here, a phone call there, twisted the odd arm, and global crisis was avoided.
But the LTCM debacle gave us an early taste of what was set to follow. The company’s investment approach was based on an investment model that was built on highly complex algorithms. The creators of these algorithms won the Nobel Memorial Prize in Economics for their troubles. The clever mathematicians overlooked some important points. They overlooked the fact that LTCM changed the global market. Other companies factored in what they reckoned LTCM were doing, which to some extent nullified LTCM’s own strategy. LTCM also failed to take into consideration the extent to which risk is correlated.
Now forward wind the clock. The dotcom crash led to a wider stock market crash. Expectations in the late 1990s had just become daft. Today, the FTSE 100 is still around 1500 below the dotcom peak. Alan Greenspan waded in, cut interest rates, and once again meltdown was averted.
Then, blow us down with a feather, mortgage securitisation came along. The similarities with LTCM were scary. Once again, bankers failed to take into account that the risks they were taking were being duplicated across the financial system. They failed to take into account that their own actions were distorting the market.
Mortgage securitisation seemed like such a good idea. Investments were backed by property. For as long as property kept going up, risk was covered. But the very act of apparently reducing the risk of mortgage lending had the effect of encouraging more risk taking, which in turn led to a property bubble. When this burst in the US… well you know the rest.
So that’s three major crises in ten years. In all three cases the full pain was avoided thanks to actions taken by central banks and governments. But this left the danger that since we had avoided experiencing the full pain, we hadn’t learnt our lesson.
Now the Risk Report is warning that: “Fiscal crises and unemployment, underinvestment in infrastructure and chronic disease are identified as the pivotal areas of risk over the next years.”
The Report also warns that there are “also a number of risks to keep on the radar, including the economic and social costs of transnational crime and corruption, biodiversity losses and risks to critical systems from cybervulnerability.”
It continues: “The events of the past year have highlighted the systemic nature of global risks and the need to rethink how to manage and respond to them. Reverting to ‘business as usual’ could have serious implications in the long term in several risk areas. This reflects the premise at the core of the Global Risk Network’s work that global risks do not manifest themselves in isolation.”
Among the dangers they cited included the threats of fiscal deficit, well we all know about that. But the biggest risk cited seemed to relate to China, and in particular the dangers that the Chinese investment boom does indeed turn out to be a bubble. They are also worried about the danger of a wider crash in asset prices. The report also cited the danger of over regulation, retrenchment from globalisation, a new spike in energy costs and food volatility. It also mentioned things like the danger of chronic diseases, although it is not clear what we can do about that.
As you know, many people would list quantitative easing amongst the big dangers. They fear it will lead to hyper-inflation. It seems that the more likely risk is that consumers have turned so against debt, that they will not want to borrow to fund their spending, no matter how cheap credit is. Instead, the surplus money is boosting asset prices.
We may see a more extreme example of the experience of the mid noughties.
Most products, especially ones that require labour intensive production in their manufacture, will see deflation. Raw materials on the other hand are likely to rise in price. So too may asset prices, at least for a while. But this time, a bubble in asset prices is unlikely to last for so long.
Is there hope we can avoid crisis.
Of course there is. It seems to us, that the one factor that has come into play over the last decade which was not there in the past, was the Internet. The lightning fast way in which information can now be sent around the world, may well have stood behind the recent bubbles.
But equally the Internet can be a force for innovation. Innovation should create productivity. And greater productivity makes debts more affordable.
Excellent article. Encapsulates and confirms my assessment. How long can we go on fooling ourselves that the medicine was more than sticking plaster? We need to learn from the mistakes – but we rarely do! Keep looking for Black Swans.