The magnitude of the credit problem is bigger than expected, but let’s not act like we are surprised by the the slowing economy. Let’s make three simple points about business cycles:
1. Lending standards were relaxed which increased the risk of default. Generally, lending standards are always relaxed as we move further away from the last recession. Bad behavior is discounted as we move further away from the last time poor lending practices were employed.
2. Interest rates came off significant lows which increased the cost of borrowing. While still low, the Fed fund rate went from 1% to 5.25 in a little over 2 years. As economies improve, rates go up which reduces lending.
3. A slowing economy from the commodity shock will increase credit risk. Higher credit risk, tightening credit standards, higher risk premiums are all part of the normal credit cycle. Credit spreads should be higher as the economy slows.
The three stylized facts about business cycles exist no matter what kind of regulation or even if there was no greed on Wall Street. A bail-out is not going to change the normal behavior of the credit cycle. There was no unforeseen event like Nassim Taleb’s “Black Swan”. (The stock market crash was a different story.) Firms are expected to fail. Given the central role finance has played in the US service economy, it should not be surprised that we have had bank and brokerage failures. This has happened in the recession of 1990. Citibank almost failed at that time. The saving and loan industry was almost destroyed when coupled with the excesses of the 1980’s.
Why are we bringing these issues up? Because whatever the policies or bail-out plans that are put forth, there will still be significant pain as the economy adjusts. We have to accept this truth.
2 comments:
Yes, it may well be true that we should have seen the credit crisis coming. Many did. But who would have thought that a person not paying their mortgage in Ohio would effect the balance sheet of a small country town in Australia causing redundancies. The "black swan" event may still be in the pipeline. Part of this concept is having respect for what one doesn't know. The global financial environment is changing on an hourly basis. World leaders who did not see this coming are now presiding over the "rescue". We are wise to look at 1929, 1974 and 1987. Somehow I feel this will end with a different twist. Perhaps hperinflation. But thats only a hunch.
If there is a "Black Swan" event, it is not the credit crisis but the response to the crisis. Or more importantly, the lack of response by the market to the action by the central banks.
The expectation was that the good old monetary policy of cutting rates would have been enough. The Fed was wrong. The expectation that providing a market for the illiquid assets would be enough. The Treasury was wrong. The belief that ballooning the central bank balance sheet would be enough. The Fed was again wrong. Of course, time has been compressed and the cumulative effects of these efforts may work, but it is not clear how or when the response will come.
No one expected that we would be having a discussion about the end of capitalism. I wrote my comments on the October 3rd and I have been truly surprised in the last two weeks.
The problem has been identification. we have been fighting a banking crisis, a credit crisis, an overvalued stock market, and a commodity shock all at the same time. Our response has been singular to each and the tools at hand may not be able to solve everything.
We cannot ask for lower leverage in the markets and offer more credit. We cannot stop the cyclical behavior of stocks at the outset of a recession through unlimited guarantees. Financial pain cannot be avoided. It can be postponed but never eliminated. Risk can only be shifted not destroyed.
The lessons of the past panics should be studied but all suggest a level of uniqueness that cannot compare with 2008.
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