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Economics Weekly - Financial markets: forever blowing bubbles?

Economics Weekly 15 September 2008


Financial markets: forever blowing bubbles?


Are some institutions too big to fail?

The bail out of Fannie Mae and Freddie Mac is ‘ of the largest financial interventions not only in US history but in any country’s history. But the costs to the government is manageable’ says an analyst at S&P. The liabilities of the two GSEs come to $5.4 trillion and will be added to the US government’s gross financial liabilities, though it will not impact its credit ratings say many (though costs associated with insuring against US government debt default - CDS spreads – reached some 20 basis points on the news, or $20,000 for every $10m of debt). Some $200bn has been set aside by the US authorities for potential losses on the assets of the agencies, but the cost is more likely to be $325bn according to S&P, some 2.3% of US gdp. This highlights the ever rising costs of the financial bubbles that have plagued the world economy in the last 10 years, in part related to US monetary policy in our view but also global monetary trends. So many financial firms have become ‘too big to fail’ one has to wonder where this process of adding private sector debt to the public sector will stop. What will ultimately prevent it, of course, is a situation in which the public sector also becomes unable to take on any more debt.


A decade of financial market bubbles

Although this should be of major concern, it is not the central issue we concentrate on here, rather we focus on what economic and financial market trends may have helped to initiate the conditions that can give rise to such huge risk taking. But we believe that in the 1990’s - 2000’s the reaction of central banks to financial market crises has contributed to a sense that asset prices cannot be allowed to fall too sharply, or key firms

to fail. This has resulted in an asymmetric policy responses (i.e. doing nothing to prevent booms / profit peaks but protecting downturns by lowering interest rates to prevent failures and mitigate losses) that has encouraged ever greater risk taking by the private sector as it senses that the public sector will step in should things worsen too much. This has helped lead to a decade in which financial markets losses and crashes are seemingly becoming more frequent and getting bigger. Chart a clearly shows that in the decade to 2008, there have been about 4 financial booms and busts. How has the economic and financial market environment contributed to this?


Economic and financial market developments encouraged bubbles by increasing liquidity and lowering the cost of borrowing…

Efforts to control price and wage inflation finally paid off in a sustained and significant manner from around the mid 1990 onwards, as shown in chart b. This fall in global price inflation led to cuts in nominal interest rates and a subsequent fall in ‘real’ or inflation adjusted interest rates see chart c. This massive fall in the real cost of capital encouraged a burst of borrowing, and spending, by households and individuals. In turn, this contributed to a boom in economic growth and a sharp rise in money supply, see chart d. Indeed, real interest rates were negative between 2003 and 2005, see chart c again. (Some of the current global imbalances, excessive budget and trade deficits in the US and UK and excessive surpluses in the Japan and large emerging markets, developed during this period of fast growth and strong borrowing, the latter especially in the advanced economies). The consequences of fast economic growth, low interest rates and plentiful liquidity is best exemplified in the monetary data, chart d, which shows how rapidly its growth expanded.


…but this has resulted in greater risk taking and more frequent boom / busts in financial markets in the period

This burst of liquidity also showed up in asset price inflation, see chart e, and in the rapid expansion of credit and derivatives instruments that were designed to boost returns at a time when low interest rates had lowered them sharply. This increased risk taking - and the increased leverage that it implied - is highlighted in charts f and g. So there were regular booms and busts in the last decade. In the latest episode, the explosive growth in derivatives was predicated on a low inflation, low interest rate environment persisting far into the future. Once this changed, the huge bets were exposed as the underlying assets on which they were based fell sharply in value. Of course, what triggered the crash was a rise in inflation and hence a subsequent rise in nominal interest rates and rising defaults on mortgage securities as the housing bubble burst.


…and preventing it in the future will be hard to do

But knowing what may have contributed to this decade of financial market bubbles is not the same as being able to avoid them in the future. The simple answer would be for central banks not to rescue firms by cutting rates too much and to raise official rates to prevent bubbles from developing or taking other measures to limit excessive risk taking. But this is clearly harder to achieve than to suggest. After all, as chart c shows, real interest rates are still very low, yet many are calling for further cuts in nominal interest rates in order to prevent further banking problems (that are undoubtedly serious) that are impacting the rest of the economy. But the risk is that taking action to help them, just means the problem becomes bigger the next time. The end game, of course, is that there will come a time when the public sector is unable to help because it is too highly indebted and the biggest crash of all will then occur. We hope not, but perhaps that is what it may take to change attitudes to risk taking.

Trevor Williams, Chief Economist, Corporate Markets


Weekly economic data preview W/c 15 September 2008


UK data to dominate this week


Less stress on financial systems following the US Treasury’s rescue of Freddie Mac and Fannie Mae and growing perceptions that US economic growth compares favourably relative to Europe and Japan, have underpinned the dollar’s strength. But the central bank’s problems are far from over - this week’s data will show headline CPI rising close to 6%, jobless claims increasing 440,000 on a 4-week moving-average basis and housing market activity still weakening and the credit crisis rumbles on. All things considered though, there is negligible chance that the Fed will move interest rates from 2% on Tuesday. In the UK, the BoE is sitting uncomfortably with CPI inflation close to 5% and inflation expectations rising. But the economy is slowing sharply and there are growing signs that weaker wage growth and rising claimant count unemployment may be dampening the risk of second round inflation effects. The key German ZEW survey of investors may improve slightly, but the European economic outlook remains sobering. The Swiss central bank is widely expected to hold interest rates at 2.75% at its meeting on Thursday.


• This is an eventful week for the UK in terms of data releases. The underlying theme is that the BoE is sitting with uncomfortably high price inflation as slower economic growth starts to adversely impact jobs. Given the continuing balance of economic risks, the minutes of the 3/4 September MPC meeting, published Wednesday, may show little change in sentiment since August's 7-1-1 vote to hold interest rates at 5%. Data this week will show CPI inflation coming close to 5%, RPI above 5% and RPIX close to 6%. We will be looking closely at the monthly change in core CPI as a guide to the likelihood of inflation becoming more endemic - although well below the 4.4% headline level, it rose 1.9% in July up from 1.6% in June. Labour market data may highlight the increasing risk of economic recession as we expect jobless claims to rise for the seventh consecutive month. Moreover, falling real incomes present a continuing threat to consumer spending - 3-month average wage growth may be running at around 3.4%, well below RPI inflation. Therefore, although monthly retail sales data have been very volatile, annual volume growth has slowed to around 2%. Public finance figures will add to the view that the Budget 2008 full year target of £43bn is likely to be missed. Money supply and M4 sterling lending data are likely to show over growth is robust.


• In the US, the Fed is widely expected to hold interest rates at 2%. In our view, it will not start raising rates until there is proof that the economy is on the right side of growth. This week’s data releases will certainly not provide strong enough evidence that this is the case. Industrial production in August may grow another 0.2% on the month, the Empire State Manufacturing index may stay positive for the second consecutive month and the Philadelphia Fed manufacturing survey may improve further from April’s low. Housing starts and building permits in August may support stable US housing activity, but not fullscale recovery. Initial weekly unemployment claims of over 440,000 will cause additional concern about weakness in the US jobs market. Finally, high commodity prices have prevented the muchneeded adjustment in the US’s external deficit - the Q2 current account deficit may deteriorate to over $180bn from $176bn in Q1. But the non-oil deficit is shrinking fast.


• The key data release this week from the eurozone is the German ZEW investor survey, which could improve to -54 in September from -55.7 in August and a weak point of -63.7 in July. Reasons for improvement include the US government’s plans for Freddie Mac and Fannie Mae which positively impacted global banking, oil price retrenchment and improved export prospects due to the weaker euro. However, this will not mask concern that the real eurozone economy may be in for another quarter of contraction in Q3 following a 0.2% decline in Q2. EU-15 CPI is likely to be confirmed at 3.8% in August, possibly having peaked at 4% in June/July.

Nichola James, Senior Economist



Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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