When Lord Cornwallis surrendered to George Washington at the Battle of Yorktown in 1781 his infantry band played “The world turned upside down”. Nothing could be a more apt metaphor for the global financial markets in the latter half of 2008. The established economic orthodoxies have been progressively jettisoned as the global markets entered an unprecedented phase of meltdown and fear drove out greed as the overriding driving force.
The early years of this century saw the greatest credit boom in history. Leverage was piled on leverage through opaque derivatives and for some time the world has been sailing on the Titanic unaware of the looming icebergs. That came to an end with the collapse of major US, UK and European financial giants over the summer and autumn of 2008. One after another icons disappeared with dizzying rapidity: Bear Stearns, Fannie Mae, Freddie Mac, Lehman Bros., AIG, Washington Mutual, Citigroup etc., in the US and Northern Rock and Bradford and Bingley in the UK all collapsed, were merged or fell into government ownership. In the space of a few weeks the once proud US investment bank industry ceased to exist as standalone operations, being either merged or converted into commercial banks.
The wealth losses from write downs in property values and stock market capitalization have been on an almost imaginable scale, over $20 trillion in the case of the US as compared with a GDP of under $14 trillion. Globally, the figures are comparable for stock market losses of at least $24 trillion worldwide, including the US, and $16 trillion excluding. And there is more to come since commercial property losses, prime loans and credit card losses have yet to be recognized. It is the first crisis of the globalized era and as Charlie Bean, the deputy governor of the Bank of England said, perhaps the greatest financial crisis in human history.
The financial collapse has now morphed into the real economy — especially the automobile industry in the US — requiring systemic approaches on both a national and a global perspective to try and mitigate and shorten a threatened long and debilitating recession/depression. The banking sectors in the US and the UK have been crippled and despite frantic efforts to recapitalize they are hoarding liquidity and showing a great reluctance to lend even to other major institutions. We are now facing a fundamental crisis of capitalism in its spiritual homeland. The very tenets of the free market have been junked by a panicked Bush administration, the most right wing in over 100 years, as nationalizations, bailouts and new funding initiatives have followed in rapid succession through either the Treasury or the Federal Reserve. The most recent estimate by Bloomberg was that the administration had committed $8 trillion to the economy since September mostly through the Fed’s own balance sheet.
The monetary base, which is the fuel for future money supply increases, more than doubled in the six weeks after the collapse of Lehman Brothers in mid September. All pretence about fiscal prudence has been junked and the US deficit is expected to exceed 10 percent GDP, perhaps considerably.
The National Bureau of Economic Research formally announced in December 2008 that the US economy had been in recession since December 2007 and unemployment is increasing rapidly — over 2.5 million will be added to the unemployment rolls in 2008.
The situation is similar in the UK and much of continental Europe, especially the extremities that had property booms based on low euro interest rates, such as Ireland, Spain, Portugal and parts of Eastern Europe. Iceland was a special case, with its oversized banking sector collapsing and being forced to turn to the IMF and others for survival.
Bretton Woods II
With the US in meltdown and suffering an interregnum between the Bush and Obama administrations the first ever meeting of the 20 largest economies (G-20) was called and met in Washington to discuss the way forward. The meeting was labeled Bretton Woods II, after the meetings in 1944 that established the post World War II by founding the IMF and the World Bank and the convertibility of the US dollar into gold as the world’s reserve currency. However, whilst Bretton Woods I had been two years in the making and the meetings lasted three weeks, BW II had been three weeks in the making and the meeting lasted a few hours. Nevertheless, the meeting was significant. In a real sense it marked a changing of the guard: The transition from the US as the sole hyper-power to the first among equals.
The G-20 meeting was not called by the US but by the Europeans and those restive countries holding huge levels of dollar reserves, such as the Chinese and the oil rich Middle Easterners with large sovereign wealth funds. To help the global economy these sovereign wealth funds must be mobilized partly through the IMF and World Bank. Unfortunately, till now the governance of these institutions has reflected global economic power in 1945 not 2008 and, as a result, the rising powers — the BRICs (Brazil, Russia, India, and China) Asia and the Middle East — are gravely underrepresented whilst the US and Europe are hugely Over-represented. In contrast to normal banking practice the borrowers have been setting the agenda.
Necessity being the mother of invention, there is now a commitment to a substantial and timely reform in IMF voting power favoring the emerging powers; in return for which the IMF would receive greatly increased funding from the Arabs, the Chinese and the Japanese. In addition, there was a general consensus that most countries would take fiscal stimulatory measures to mitigate the recession. Further, it was agreed that there needed to be more active regulation of the financial sectors, nationally and globally.
Outlook for 2009
Since the situation keeps changing that any projections have much greater uncertainty than normal. On the assumption that the financial sector has been stabilized by the emergency actions in October and November — and that is a brave assumption — then the IMF projects, without much confidence, global growth in 2009 to fall to 2.2 percent from the 5 percent levels of 2005-2007 with the US, Europe, UK and Japan all in recession throughout 2009. China and India are penciled in for 8.5 percent and 6.3 percent respectively, both of which are more likely to be on the high rather than the low side, and Brazil and Russia in the 3 percent range.
It will be a different world with the government rampant again everywhere in fiscal and monetary policy, regulation and nationalization, for the first time since the 1970s, with the hope that this activism avoids both the general stagflation of the 1970s as well as Japan’s wasted decade of the 1990s. These are long odds and will require luck as well as judgment. Activism could lead into a slide toward protectionism although Obama’s economic team is first rate and opposed to such slippage. Inflation will not be a problem next year but beyond that timeframe it could well return as a recovery sets in and the velocity of circulation picks up. It may be seen as the way out of the debt situation.
For the markets, crisis generates great opportunities and they are present today in abundance for those with liquidity and fortitude. The year 2009 is likely to be the most challenging year economically in six or seven decades but could well be more rewarding for investors than this year, especially in Asia. Just remember Lord Cornwallis — his world was turned upside down at Yorktown, but he went on to bigger and better things in Asia (specifically India).
(Habib F. Faris [[email protected]] is CEO & managing director of FinaVestment Ltd., London.)
