The bail out of Fannie
Mae and Freddie Mac is â€˜...one of the largest financial interventions not only
in US history but in any countryâ€™s
history. But the costs to the government is manageableâ€™ says an analyst at
S&P. The liabilities of the two GSEs come to $5.4 trillion and will be
added to the US governmentâ€™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 â€“ 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 â€˜too
big to failâ€™ 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
A decade of financial
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 1990â€™s - 2000â€™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 borrowingâ€¦
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 â€˜realâ€™
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.
â€¦but this has resulted
in greater risk taking and more frequent boom / busts in financial markets in the
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.
â€¦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.
Weekly economic data preview W/c
UK data to dominate this
Less stress on financial
systems following the US Treasuryâ€™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 dollarâ€™s strength. But the central bankâ€™s problems
are far from over - this weekâ€™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
â€¢ 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 Â£43bn is likely to be missed.
Money supply and M4 sterling lending data are likely to show over growth is
â€¢ 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 weekâ€™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 Aprilâ€™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 USâ€™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.
â€¢ 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 governmentâ€™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
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