Five years ago this week the world woke up to the fact that a credit crunch was definitely happening. On 9 August 2007, central bankers became so alarmed by banks' reluctance to lend to each other that they took emergency action. The European Central Bank and the US Federal Reserve injected a combined $90bn into financial markets....
The central bank called it a piece of "fine tuning", but investors knew it was far more serious. The FTSE lost 121 points that day, and in the US the Dow Jones average fell by 387.
A squall that had appeared at two French investment funds exposed to US sub-prime loans was about to develop into a hurricane. Adam Applegarth, boss of Northern Rock, where queues would form the next month, later called 9 August "the day the world changed".
Even so, at the time few would have predicted that half a decade later the world, or at least the western part, would still be struggling with the consequences....Actually, your humble blogger predicted at that time that the global economy would continue to struggle as it was in a downward spiral that could only be arrested by bringing transparency to all the opaque corners of the global financial system.
Please note, that when it comes to our current financial crisis, I have a very good track record making predictions. This includes being among the few who predicted the crisis and subsequently predicting on this blog which of the policy responses were not going to work and why.
How much longer can it go on?
"After five years, we are in a worse place than when we started," wrote Jamil Baz, chief investment strategist at hedge fund GLG, in an eye-catching analysis last month. He observed that total debt – meaning government, household, financial and corporate debt – is higher than in 2007 in 11 economies under the microscope. They are Canada, Germany, Greece, France, Ireland, Italy, Japan, Spain, Portugal, the UK and the US.Mr. Baz's analysis confirms my prediction about the downward spiral.
Baz made five predictions.
First, "all the perceived unpleasantness of the past few years is merely a warm-up act for the greater crisis to come", because the need to get debt levels down remains.True.
Second, history says debt cannot be reduced by more than 10 percentage points a year without causing social unrest, which suggests a minimum of 15 to 20 years to achieve healthy conditions for growth.It depends on how debt is reduced.
Regular readers know that debt can and should be reduced by banks recognizing the losses on the excess debt in the financial system. Were this to occur, the only social unrest would be bankers complaining about not receiving large cash bonuses.
Third, the economic impact of cutting debt will be massive because a multiplier effect occurs when spending is reduced.Not true. By having the banks absorb the losses, spending is not reduced.
Fourth, share prices may still be too high because corporate profits will be hit.To the extent that the real economy is made to carry the burden of the excess debt and the pension fund/real economy death spiral is triggered, then corporate profits will definitely be hit.
As for share prices, they may or may not be too high.
Fifth, there is no magic bullet. Interest rates are already on the floor and even back-door inflation would not help because bond yields would soar and, in any case, many government liabilities are inflation-linked.Not true. There is a magic bullet. The magic bullet is to use our financial system as it is designed to be used when there is excess debt. Require the banks to absorb the losses on this excess debt.
With their deposit insurance and access to central bank funding, banks are designed to operate and support the real economy even when they have negative book capital levels. Taxpayers act as their silent equity partners while they are rebuilding their book capital levels.
In return for being silent equity partners, taxpayers get the benefit of requiring banks to absorb all of the losses on the excess debt today.