When credit imploded

George Magnus

The global banking crisis has sent Western economies into the financial abyss. The man widely credited with predicting that the US sub-prime mortgage crisis would trigger a worldwide recession, George Magnus,  explains how we got here and assesses the outlook for the USA, China and Europe.

On Friday 12 September 2008, about a year after the finan­cial crisis started to erupt and the final working day before America’s fourth largest investment bank, Lehman Broth­ers, filed for bankruptcy, the UBS Investment Bank’s normally noisy trading floor – the world’s largest – was deathly quiet. You could sense the seizure that had gripped financial markets. Global lending and borrowing had ground to a halt as a once-in-a-genera­tion financial crisis cast long, dark shadows.

The rest, as they say, is history. A systemic collapse in the bank­ing system was averted but the global economy fell into a deep recession. By spring 2009, in desperation, governments and central banks, in a rare show of unity, had resorted to extraordinary fiscal, monetary and budgetary policies and the nationalisation of banks, in order to stabilise the financial system and kick-start the world economy again. To a degree, they have succeeded, at least in avert­ing worst-case outcomes. But the crisis hasn’t ended.

Dysfunctional banks are unable or unwilling to create credit, es­pecially for small- and medium-size companies and households. Grave structural financial and economic problems threaten the future of the eurozone. And the global economy remains fragile. Among Western economies, only the USA has succeeded in lift­ing its GDP to a level just beyond the last peak in early 2008, and that achievement is overshadowed by the fact that if this were a normal business cycle, GDP would typically have risen about 10 percent by now. In addition, China and other major emerging mar­kets, which had contributed most to global growth in 2009-11, are also slowing down. China, in particular, is facing a cocktail of a weakening property sector, falling house prices and bad debts aris­ing from its own credit boom that was unleashed in 2009-10 to strengthen a faltering economy.

The North Atlantic crisis, as the Chinese call it, has also spread in the meantime from banks and households to governments. Gov­ernment debt and deficits have soared to exceptional levels as the costs of financial rescues have mounted and because of lost tax revenues, partly due to weak growth and rising unemployment, and permanently due to the collapse in revenues from the once-buoy­ant housing and banking sectors. The unresolved eurozone sover­eign debt crisis represents a major threat to global stability. But it isn’t about budgetary misbehaviour, except perhaps in the case of Greece. Ireland, Spain, Portugal and even Italy had been fiscally prudent in the years before the crisis. Fundamentally, the crisis es­calated when credit flows between member states became sclerot­ic. Southern European countries in particular depended on cheap and free-flowing credit for growth and rising living standards in the first decade of monetary union, and this allowed their competitive­ness and political governance to go into serious decline.

Our Western predicament is that the banking crisis has robbed us of credit creation as a means of driving economic growth, and tor­pedoed the housing, construction and financial services sectors that contributed over 60 percent of the economic growth between 2004 and 2007 in, for example, the USA and UK. As yet, we haven’t found replacements to drive growth, and have to endure the painful and protracted process of reducing levels of debt and finding new ways to create income and employment.

Banking crises have occurred for hundreds of years, and sover­eign debt defaults can be traced back to before the birth of Jesus Christ. Financial turbulence invariably follows periods of exces­sive credit creation and speculation, and always ends badly. The US economist, author and diplomat J. K. Galbraith, referring to historical periods of financial euphoria, once quipped that “the speculative episode always ends not with a whimper but with a bang”. And another US economist, Hyman Minsky, explained over 25 years ago how financial crises are endogenous to capitalism. He demonstrated how the credit creation process moves through two relatively benign stages, before reaching a third, the so-called ‘Ponzi’ stage, where borrowers rely on debt and rising asset pric­es to be able to service and repay their loans. Once inflated asset prices start to crumble, and confidence and the value of collateral erode, the entire structure of credit can implode, leaving wide­spread losses and bankruptcies, and exposing the financial sector to a systemic collapse.

Our crisis erupted in 2008 in the wake of a long credit boom, dat­ing back to the 1980s, which reached its Ponzi stage around 2000. The main focus of speculation and financial excess was in the US revenues from so-called sub-prime lending. This was the practice of lending money to high-risk borrowers on imprudent multiples of income, and often without confirmation or documentation that the loans were affordable, serviceable and repayable. Sub-prime lending spread to other countries, including the UK and Ireland, and housing booms occurred in several other countries in Europe, partly fuelled by the easy and cheap credit. When the US mortgage financing bubble started to burst in late 2006, losses and forced asset sales spread like wildfire to other non-housing parts of the US economy, and to other countries and banking systems. Here, you could say, was the dark side of financial globalisation, thanks to an interconnectedness that had only ever been praised for its efficiency.

And the banking crisis spread from sub-prime lending. As is well known, sub-prime and other home mortgages were pooled into se­curities that were given the highest credit ratings, sold by banks to investors and traded all over the world. These ‘structured’, or securitised, mortgage products were designed to spread risk and to give investors income to compensate for low world interest rates, arising from falling inflation and increasing flows of capital com­ing from China and other emerging markets, which were invested in Western financial markets. These structured products were also created using non-housing assets. Even though banks claimed only to be ‘intermediaries’ between buyers and sellers of complex fi­nancial products, they also owned them, and more generally, built up loan assets and liabilities that were 40 to 50 times their capital. This leverage, as it is known, was the downfall of the banking sys­tem when the rising asset prices, on which it was based, went into reverse, leaving the banks unable to fund themselves any longer or, in some cases, insolvent.

The stewards’ inquiry into the banking crisis isn’t over. We still want to know who was to blame. But, meanwhile, we have to get on and rebuild. Domestic and global regulatory and supervisory institutions are engaged in a continuing struggle, often against strong vested interests, to make banks safer and able to fail without imposing excessive demands on taxpayers. In the UK, for exam­ple, the Independent Commission on Banking put forward reform proposals in 2011, many of which Britain’s coalition government has vowed to take up.

Banks are under pressure to lift and sustain higher ratios of loss-absorbing capital to total assets, to shrink the loans and deposits on their balance sheets, and to observe stronger funding and liquid­ity requirements. They are also likely to succumb to proposals for a new ‘resolution authority’, or rules according to which failing banks would be wound up or forced to merge.

US and British banks appear to have emerged from the abyss comparatively well, and in the USA, bank lending to industrial and commercial companies has started to rise a little. But in the UK, and in Europe in general, despite exhortations and initiatives from officials for banks to lend more, lending remains stagnant, as banks continue to reduce their assets and liabilities, and scrutinise their own willingness to lend to one another. In the eurozone, these problems became so acute in late 2010 that the European Central Bank (ECB) was obliged to arrange large-scale, cheap three-year loans to help banks weather the storm. Surveys conducted by the Bank of England and the ECB indicate that banks’ willingness to lend is still heavily impaired, and that they see few viable credit demand opportunities in the current weak economic environment.

What to do about banks generates a lot of heat. On one level, you get indignation, and a desire to restrain and tax them. On another, you can acknowledge a systemic (and not historically uncommon) problem that will take years to address, and that calls for new ideas about what to do in the interim. Proposals range from state guaran­tees of loans to small companies, to the direct intervention of the government in capitalising or guaranteeing new banks or agencies to promote infrastructure and green projects. The British govern­ment, for example, has authorised the creation of a £3-billion green bank, but this has yet to see the light of day.

The appropriate role of the government, as opposed to private markets, in reconstructing the credit environment is hotly debated. But it is a question that transcends the banking system to touch at the heart of our capitalist economic model, especially at a time when it is fashionable to point to a more statist version of success­ful capitalism in China and a host of other emerging markets. The comparison with essentially poor countries at relatively low levels of human development shouldn’t be taken too far. But a shift in our state/markets continuum is surely occurring, regardless.

Although 2012 has begun with a bit more spring in the world’s economic step than seemed likely at the turn of the year, the global economic system remains fragile. There is still an absence of lending to drive growth, and the absence of sustained spending increases be­cause of the pressure on banks and households to realign depreciated assets with continuing liabilities, as well as the contractionary nature of continuous and widespread public debt and deficit reduction.

American economic performance certainly looks a lot sharper than it does in Europe, where GDP is expected to contract this year. In several respects, the USA has ‘moved on’ from the bank­ing crisis more successfully, though it is fair to point out that, as yet, political dysfunction has prevented the crafting of a credible medium-term budget strategy designed to sustain the confidence in creditors that its deficits and debt will stabilise and then fall. This poisoned chalice will be passed to the next US president and Congress in early 2013.

Eurozone countries agreed in late February to a second financial bailout package for Greece, bypassing the looming threat of its im­minent default and possible exit from the eurozone. But only for the time being. Both developments are likely before long. Mean­while, a newly empowered Germany has set an agenda for a ‘fiscal compact’, which would bind member states ever more closely to rules and penalties designed to keep governments fiscally prudent. Whether the eurozone succeeds with this task and maintains its existing membership is a moot point. The existence of the euro-system itself is dependent on overcoming crucial issues of sover­eignty and national self-determination, which will doubtless inter­vene ever more intrusively with the process of integration, and it is far from clear if these can be satisfactorily resolved.

In China, the property market is faltering and is characterised by failed land auctions, reduced cash flow and increasing debt prob­lems among local governments, property developers and state-owned enterprises, as well as falling property transaction volumes and prices. As in the West, these phenomena are the outcomes of a runaway credit boom that the government is trying to tame. It is the tip of an iceberg that is really about the growing dependence of the Chinese economy on unsustainable credit and investment spend­ing to sustain high economic growth and, therefore, social stability.

From the crow’s nest, it is clear that banks are only partway through the post-crisis clean-up, that in some countries, their vi­ability remains precarious, and that the prospects for the global economy hang in the balance. For the moment, financial markets are fairly comfortable that ‘muddling along’ is the most likely out­come. But these moments, as we have seen already, can be fleeting, and even if 2012 should come and go without major incident, there will be plenty to keep us on our toes in 2013-14.

About the author:

George Magnus is Senior Economic Adviser, UBS, and author of Uprising: Will Emerging Markets Shape or Shake the World Economy? (2010)


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