By Vincent J. Truglia
I have lived in the trenches through many financial crises over my 36-year career as a Wall Street economist. Given that experience, I fear the Fed is about to trigger another crisis.
Most past financial crises were international in nature, and usually set-off by recessions or slowdowns in economic growth in the advanced industrial world. Some Americans may remember the economic dislocations caused by the sudden quadrupling of oil prices in 1973. That triggered a decades long battle with inflation. The first salvo in the anti-inflation war was when the Fed raised interest rates to double-digit levels starting in the late 1970s, causing back-to-back recessions in the US.
The World of Defaultia
Latin America and other emerging market regions in the 1980s experienced a “lost decade.” Why? The commodity price boom of the 70s, benefitting most EM countries, caused huge increases in wasteful investment. Inevitably, as demand remained weak in the advanced industrial countries in the 80s, especially after the Volcker induced recessions, this eventually translated into lower commodity prices and less capital available to refinance EM debts.
The Collapse of Communism and Apartheid
Literally dozens of countries defaulted on their debts in the 1980s. In Eastern Europe, although not often cited, defaults in the Soviet Union, Poland, Yugoslavia and Romania were a major economic reason for the collapse of Communism. In addition, this widespread crisis provided an important economic factor laying the groundwork for the collapse of apartheid regime in South Africa following that country’s 1985 financial crisis.
US and European Banks Survived
Although almost all major US and European banks were severely impacted by the EM-induced debt crisis, since there was far less transparency in banking then compared to now, the US and European banking systems survived the crisis pretty much intact, although certain regional banks in Texas and New England were forced into government-sponsored mergers, often with out-of-state banks.
The resolution of the EM crisis of the 1980s had both beneficial and deleterious consequences. One of the most important benefits was that with the advance of computer technology, and the speed of communication, it became easier to repackage the defaulted debt into new securities. Thus was born the Brady bond market, and eventually, as the market matured, EM countries were able to issue cross-border bonds in their own right.
Crises Were Not Limited to EM Countries
Although most financial crises, up to that point, had centered in the EM world, as Europe attempted a new stage of economic integration trying to prepare for a new international currency, European governments were forced to begin aligning their currencies, which was mainly accomplished by creating bands within which European currencies were supposed to float. However, by 1992, severe stress was emerging in a number of countries, especially the UK and Italy. The UK made the smart decision by simply pulling out of the system. Italy tried to remain within the bands, and Italy was set up for crisis after crisis, which although basically economic in nature, eventually caused upheavals in Italy’s political system, which are still reverberating today.
The UK and Italy were not alone among the advanced countries to suffer financial crises. Canada, Norway and Sweden also had major crises in the 1990s, causing significant reforms in their welfare systems.
As Europe was beginning to calm down, East Asia went into full-blown crisis in 1997. Although it started with an exchange rate problem in Thailand, the crisis quickly engulfed the region, involving Indonesia, Malaysia, the Philippines and South Korea. The crisis was exacerbated by developments in Japan, which was still trying to recover from bursting its own financial bubble of the late 1980s.
If people thought things couldn’t get worse, they did. By late 1998, Russia defaulted on its government bonds. This set off a worldwide panic, which caused the bond market to seize up as seriously as in 2008, except that the seizure fortunately didn’t last as long because its origins were once again in EM countries not in the developed world.
What made the 1997 and 1998 crises so interesting was that countries, which were not directly related to the source of the crisis, were impacted.
I would argue it goes back to the advances in financial engineering, which became common in the 1990s. World financial markets were becoming intertwined in a way not seen since the days of the gold standard, except this time they were related through hedging operations. Brazilian bonds were being used to hedge Russian bonds. As asset prices fell in Russia and then Brazil, profitable positions in Danish mortgages were hit to help recoup losses elsewhere. There were lots of interrelationships that were not obvious to regulators or even market participants.
One thing was becoming clearer, financial crises were becoming more frequent and with greater amplitudes.
The Dot.Com Bust
Moving into this century, we had the dot-com bust of 2001. All seemed quiet for a while, except that as we all know, we were laying the groundwork for another crisis that would dwarf any crisis of the last 50 years. How did this last crisis happen?
The story has repeated itself, but as with all new crises, it also morphed into something new. Relatively loose monetary and fiscal policies in the US and Europe in the early 2000s –- in the US it was related to wars in Iraq and Afghanistan, and in Europe it was related to the recent introduction of the euro and low interest rates –provided enough demand to set the stage for a housing bubble, not just in the US, but also in other countries including Ireland and Spain. Liquidity wasn’t enough. The big change, especially in the US, once again lay with financial engineering.
Traditional 30 year mortgages had become passé. By 2006-2007 over half of all new mortgages were of the more exotic variety, including short-term ARMs, the infamous option-arm mortgage and interest only mortgages. I don’t need to rehash what happened when the housing market collapsed. We had the Great Recession.
The problem we faced was at first dealt with appropriately by joint efforts by governments and, in the US, by the Fed. Together, both institutions brought the country back from the brink. Then by 2010, fiscal fears overwhelmed the legislative branch, causing a sharp contraction at the federal and state level. A similar problem arose in Europe. European governments were beset by banking crises which turned into sovereign debt crises. There, however, the response was worse. For years the ECB (European Central Bank) was not as accommodative as the Fed. However, what was worse in Europe was that the fiscal contraction was draconian.
Where does that leave us today? US fiscal policy is at least not contracting at the rate it has since 2010. However, it needs to be more stimulatory. The problem of long-term unemployment is not going to be solved by monetary policy alone.
Mark Hanson And Housing
After listening to Mark Hanson and reading some of his research, I have also concluded that interest rates alone cannot solve the US housing problem. As he points out, housing affordability, despite much lower interest rates than in 2003-2006, is much worse, because today, the 30-year mortgage has again become the norm. With the exotic mortgages from that earlier period no long available, despite the decline in house prices, and lower interest rates, housing is more expensive today than it was in 2003. The implication is important. The only way to get housing genuinely jump-started is for income levels to grow significantly, or for house prices to fall further. Obviously, the former would be preferable.
As I have written before, asset prices are seriously mispriced, unless one assumes an incredibly extended period of new zero interest rates. However, even with such an assumption, we are likely to see long-term rates continue to rise. As some point, long-term rates will be more competitive compared to stocks, which now are moving up at speeds unjustified by logic.
As we are already seeing FX rates adjust in EM countries as funds flow back to the US, as the Fed continues to taper, possibly even speeding up the taper early next year, asset price adjustments will accelerate. I am sure we will wake up one day suddenly seeing a major correction in the stock market. In hindsight it will appear to have been inevitable.
The Fed has done all it can do. It can’t fix the long-term unemployment problem, nor the housing sector. It is time for governments to come forward and jumpstart the economy.
Let’s just hope the amplitude of the next financial crisis is not worse than the Great Recession.
As always, Clear and Candid.