Stephen King: In Mexico, they've seen it all before. And there are lessons for all of us
Monday, 29 September 2008
Independent.co.uk
On a business trip to Mexico last week, I was talking to some local economists and financial experts. They know a thing or two about financial crises. Mexico, after all, has had more than its fair share of problems over the last 30 years, what with the Latin American debt crisis in the early Eighties and the "Tequila crisis" in the mid-Nineties.
Their view was simple. The US – and, for that matter, parts of Europe – is experiencing the kinds of problems associated with emerging economies. It is easy to see why. The sub-prime market is a market where creditors lend to very risky borrowers, in much the same way as investors have poured money into sometimes risky emerging markets.
The growth of the US sub-prime market, in turn, depended on the increased participation of foreign investors, many of whom snapped up mortgage-backed securities in ever-larger amounts. Judged by its widening current account deficit in recent years, the same is true in the UK, too. Emerging market bubbles, of course, are also associated with heightened foreign interest.
And, as banks and other financial institutions have seen their reputations shredded in recent months, some would argue that crony capitalism – which was rife in parts of Asia in the mid-Nineties in the run-up to the 1997 crisis – has also been widespread in the US. Fannie Mae and Freddie Mac spent approaching $200m (£108m) lobbying Washington to maintain a regulation-light environment for their mortgage businesses (intriguingly, one of the big recipients of campaign funds from the mortgage giants was Barack Obama).
The similarities, though, aren't just restricted to the experience of emerging economies. Worryingly, the US and UK experiences increasingly resemble Japan's economic and financial progress at the beginning of the 1990s.
It's often forgotten that, at the end of the Eighties, Japan was considered to be something of a miracle economy. Most economists thought Japan's output would be able to grow through the 1990s at a rate of between 3 and 4 per cent a year. With falling equity and land prices and with failing banks, these hopes floundered. As the decade progressed, Japan experienced an unwelcome dose of deflationary reality.
Despite all this historical evidence, there has been an institutionalised denial of financial dangers in the US, the UK and elsewhere in the industrialised world. Whether this reflects arrogance, hubris, feelings of Western "superiority" or plain stupidity, I don't know. What's clear, however, is that the warning signs stemming from the experiences of the emerging markets and of Japan were simply ignored.
At the heart of the problem is an insistence at the macroeconomic level on the pursuit of price stability without any real reference to other signs of economic imbalance. For much of the late Eighties, Japan successfully delivered price stability, yet this achievement didn't prevent Japan from having one of the biggest financial bubbles of all time. The tell-tale signs were there in the form of big increases in equity and land prices, but the Bank of Japan and others chose to ignore them. It was only later on, when equity prices were already falling, that the Bank of Japan really began to fret about inflation and, by that stage, the seeds of future deflation had already been sown. Much the same story applies to many of the Asian countries which succumbed to economic and financial collapse in 1997 and 1998. Before the meltdown, these countries ran budget surpluses. Their inflation rates were low. What could possibly go wrong? As it turned out, many Asian countries had borrowed heavily from abroad, reflected in widening current account deficits. The foreign inflows, in turn, were often invested in madcap property ventures. Sound familiar?
Then there are the similarities with Mexico's bubble in the Nineties. Mexico did well for all sorts of reasons at the beginning of the 1990s but one key source of external support was the advent of very low interest rates in the US, put in place by a Federal Reserve keen to deal with America's early-1990s credit crunch. Low interest rates encouraged capital to leave the US. Some of it ended up in Mexico, adding rocket fuel to the growth rate south of the border. In the end, the Mexican rocket exploded and the economy fell to earth.
Low interest rates have also played a role this time around. Following the collapse in stock prices in 2000 and 2001, the Federal Reserve slashed interest rates in response to the economic chill pervading company balance sheets. Having borrowed too much through the Nineties' boom, companies chose to repay debt. The Federal Reserve feared that a sudden increase in corporate saving might throw the US economy into protracted recession. But the consequence of lower US rates was not so much additional borrowing in Mexico but, extra borrowing from US households: at the margin, much of this additional borrowing was of the sub-prime category, providing a link with emerging market crises of old.
Spotting economic and financial bubbles is no easy task. To pretend, though, that bubbles are confined only to emerging markets, is plain folly. They are a persistent feature of capitalism, whether crony or otherwise. Some bubbles might arguably serve a useful purpose – technology-related bubbles, for example, help to steer resources into the most socially-useful areas of economic activity (railways in the mid-19th century, computers in the late 20th century). Others might not cause too much lasting damage, particularly if the authorities are able to clear up the mess in a bubble's aftermath.
Bubbles related to property, though, are almost always bad news. Whereas new technologies can add to the level of well-being, property speculation too often diverts resources away from welfare-enhancing projects towards short-term monetary gain.
Most emerging market crises are violent affairs, associated with savage losses of activity in the first one or two years. That's less likely in the US this time around because of the dollar's status as the world's reserve currency. Unlike most of the emerging economies, the US borrows from abroad in its own notes and coin. When things go wrong in the US (the housing crisis is currently the biggest single problem) it's initially a bigger challenge for the overseas creditor – who discovers that the domestic value of his dollar assets is beginning to decline – than for the domestic debtor.
But that story only works for a while. As foreign creditors have chosen to steer clear of US assets, so US banks have been left with all manner of toxic waste. The counterparty risk associated with this has been instrumental in explaining why the US financial system is today in such a parlous state, and why the US economy is now threatened with a multi-year period of low growth and high unemployment.
The Paulson plan is, in effect, a taxpayer bailout designed to protect the US banking system from the consequences of foreign aversion towards US assets. It's needed because the US has, for too long, survived through the sale of dodgy assets to unsuspecting foreign creditors. Might the US, then, be the world's largest emerging market in disguise?
Stephen King is managing director of economics at HSBC
©independent.co.uk
http://www.independent.co.uk/news/business/comment/stephen-king/stephen-king-in-mexico-theyve-seen-it-all-before-and-there-are-lessons-for-all-of-us-945378.html
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