A crisis? Or a mere recession?

Business Standard, 19 March 2008

While the US economy is beset with serious difficulties, there are equilibriating forces in play which suggest that this could endup as a recession but not a crisis.

The US economy is facing substantial difficulties. Housing prices have dropped. An increasing number of households are defaulting on home loans. Losses on home loan portfolios are affecting financial firms who hold derivatives on home loans. Some financial firms have gone bankrupt, and there is uncertainty about who else might be bankrupt. With finance in difficulties, the monetary transmission is malfunctioning. Hence, while the US Fed has cut rates sharply, the full impact of these lowered rates on the economy is not going through. Inflationary expectations are worrisome.

This is undoubtedly a difficult situation. But is it a crisis? One estimate of the size of losses on sub-prime home loans is $400 billion. This is roughly 2.85% of US GDP. In India, with roughly Rs.50 lakh crore of GDP, a comparable scenario would involve home loan losses of Rs.1,43,000 crore. If such a shock hit India, one can only imagine how bad things would be.

In such difficult times, why is the US economy still rolling with the punches? Why has the US economy not collapsed in a mire of failed firms, finger-pointing by government agencies, morchas in the streets, and JPC inquiries? Understanding how this shock is being absorbed, and the equilibriating forces in play, is important in making a call on whether this is a crisis or a mere recession.

In the idealised world of securitisation, a parcel of home loans is converted into securities, which are then sold into the broad market. The ownership of these securities is dispersed amidst international hedge funds, pension funds, etc. The originator of the home loan is largely immune to the outcome : if a default takes place, the losses are borne by the owners of the securities.

Many critics of securitisation have pointed out that this theory has not quite panned out as expected. However, at the same time, there is no doubting the fact that securitisation has given a substantial dispersion of the $400 billion loss. For this reason, the impact of the massive loss on the US financial system is not as large as it might otherwise have been.

The second equilibriating channel lies in monetary policy. Unlike many other countries which have experienced crises, the US has well functioning institutions for conducting monetary policy. The US Fed has cut rates dramatically in response to difficulties in the economy. On 14th March, the 90-day treasury rate in the US had dropped to 1.16%. The impact of lowered interest rates on the economy is not as strong as it used to be, owing to difficulties in finance. However, a certain impact is surely there. Low interest rates are helping strengthen demand, and help attract smart speculators to buy assets at fire sale prices.

Difficulties in finance inflict damage on the economy when they trip up the debt financing of firms. However, US corporations are unusually under-leveraged and cash-rich. Hence, this recession-inducing channel from credit market distress to the real economy is absent. The health of US corporations today is very different from the health of Japanese firms in Japan's lost decades.

Low interest rates are doing their job in one critical respect: the decline of the dollar. Unlike other countries which have experienced crisis, the US has a floating exchange rate and an open capital account. The exchange rate pegging with capital controls, which has brought down so many emerging markets, is absent. When interest rates dropped, the dollar fell - exactly as it should. The weak dollar is bolstering net exports and helping the economy.

These effects are large. The Q4-2005 current account deficit was 7% of GDP; this has shrunk to 4.9% of GDP in Q4-2007. In other words, over these two years, the decline in the dollar contributed roughly 2% of higher demand for goods and services produced in the US.

A second remarkable feature of the decline in the dollar is the funding channel for the US through Asian central banks and governments in the middle east. For each $1 trillion of reserves held in USD assets, a 10% decline in the dollar constitutes a transfer of $100 billion to the issuer of liabilities in the US. Every Asian country should be asking whether this deal makes any sense for them, but in understanding the present situation, it's useful to note that no other country facing a crisis in the past has had such a good deal, which produces fiscal transfers in the time of need.

Unlike many countries which have experienced crises, monetary policy in the US is manned by brilliant intellectuals like Ben Bernanke and Fred Mishkin. Few people in the world understand the interplay between monetary policy and financial sector difficulties as well as them.

The Fed cut rates, but the monetary transmission was not quite working owing to difficulties in finance, so the rate cuts were not doing their job. Hence, the Fed has been innovating with new ways to get back into the game. These innovations include changing rules on collateral, reaching out to financing non-banks, etc. These strategies are on the right track and will help.

Some hedge funds and private equity funds have failed. From the viewpoint of public policy, this reiterates the case for having hedge funds and private equity funds as major players, since these failures have no repercussions. The failure of Carlyle is very different from the failure of financial firms like banks or insurance companies which have assured returns obligations to the general public. It is an excellent risk management strategy for society to have hedge funds where rich people place their money, which can blow up when times go bad inflicting losses on rich people.

In the failure of Bear Stearns, there was no bailout. Senior managers will be sacked, and the shareholders were expropriated. In this fashion, bit by bit, the losses on the housing market are being absorbed by various portfolios.

Conditions in the US are undoubtedly difficult. However, it is important to also understand the institutional depth of economic policy making, and the equilibriating responses which are in play. This may well be a recession, but it is not an emerging markets style crisis.

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