FYI | Oct 07 2008
By Greg Peel
“The lesson of the 1930s is that any country trying to reflate in isolation will be punished. The crisis will ricochet from one economy to another until everyone is crippled. We are seeing it play again in this drama as our leaders fail to rise above their narrow, parochial agendas.” – Ambrose Evans-Pritchard, UK Daily Telegraph.
“We are more frightened now for the future of the global capital markets than we have been at any time in our thirty plus years of watching, commenting upon and taking part in them.” – Dennis Gartman, The Gartman Letter.
Monday night was the night that Europe stared into an abyss of its own.
For over twelve months the disaster that has been the US financial sector has played out in world headlines as one by one hundred-year-old institutions fell like so many toppling chimneys. First, the US Federal Reserve and then the US government threw everything it had at the crisis, only to find that everything was not enough. Finally, an all-encompassing rescue package was called for, but as Washington fiddled the rest of the world found a fire spreading out of control.
The delay in passing the Troubled Asset Relief Program (as it is now known) did little to engender confidence either locally or globally, and now that details remain scant on how the TARP will be implemented, investors are taking no chances. History books will forever record the events of last week, but as to whether an immediate passage of the bill would have staved off the global collapse we are now witnessing we will never know. What we do know is that the underlying problem of a developed world choked with too much debt was not about to go away no matter what rescue package was decided upon in the US. We cannot thus suggest that the situation Europe now finds itself in could have been averted.
For all of 2008 market commentators have asked the question: What’s happening in Europe? US financial institutions had written down vast amounts of asset value, investment banks had collapsed, the two government agency mortgage lenders had needed to be saved, the world’s largest insurer needed to be saved, the country’s biggest thrift had gone under, but all the while, with only couple of exceptions, all seemed quite across the Atlantic. That has now changed.
Before the credit crunch really began to gain momentum, the OECD was of the belief the US economy could weaken significantly without affecting the rest of the world. Indeed, it believed Europe would step up to the plate, along with Japan, allowing global economic growth to remain supported. Without global weakness, the emerging economies would also continue to drive demand. But Europe is now mired just as deep as the US, if not deeper. It is now a “globalised” world, and the spread of the toxic debt disease spread just as vigorously into Europe from its roots in the US.
History will also record that in response to the global credit crisis, the European Central Bank raised its cash rate from 4.00% to 4.25%, and last week left it there. If there is one thing the world’s central bankers learnt, with the benefit of much hindsight from the Great Depression, it was that the biggest mistake central banks made at the time was to tighten lending rather than loosen it. The Fed acted accordingly, the ECB did not.
History may also soon include a chapter entitled “The European Union – A Failed Experiment”. The reason the ECB chairman Jean-Claude Trichet chose to fight growing inflation rather than address a weakening economy is because it is the ECB’s responsibility, under its umbrella structure, to control the former but not the latter. Evans-Pritchard suggests the ECB “has played a shockingly destructive role in this enveloping slump”.
“It could have offered to ‘cover’ the US Federal Reserve this spring,” continues Evans-Pritchard, “when Ben Bernanke was forced by events to slash rates to 2%. It could have at least signalled an end to monetary tightening. That is how an ally ought to behave.”
The result was a significant fall in the US dollar against the euro, an effect which pushed prices of US dollar-denominated commodities perilously higher. In the mistaken belief that Chinese demand was the sole force behind commodity price surges, speculators panicked to the upside and thus greatly exacerbated the world inflation equation. This only served to force interest rate increases from “commodity countries” such as Australia.
And that, in turn, further fuelled the world’s carry trades. The world had spent the last several years borrowing in yen and investing in the likes of the Canadian dollar, Australian dollar, Icelandic kroner, and the Russian ruble, which all offered much higher rates of interest. Carry trades were also conducted using the US dollar as a base when the Fed lowered the cash rate to 1% in 2004.
When the Fed cut its cash rate to 2%, the ECB remained on hold, and the Reserve Bank of Australia (among others) was forced to raise. Thus another opportunity arose for a US dollar carry trade, as well as the yen carry trade, safe in the belief that China and other emerging markets would continue to drive commodity demand and that the European economy would stand fast.
It was all a fantasy. When the commodity price bubble burst, most expected a sharp but short correction back to the previous trend. But when the US financial system froze again two weeks ago, precipitated by the allowed collapse of Lehman Bros and subsequent unwinding of that institution’s credit default swap and other toxic asset positions, a global recession was on the cards. Not just a US recession. The result was a collapse of all other major currencies, against the US dollar. This gives the impression of a soaring greenback.
And it also results in a lose-lose for carry traders. The commodity currencies they have invested in have crashed as commodity prices have crashed. The US dollar they have sold has surged. There is again a massive global unwinding of positions – a mass sale of assets – sending commodity and stock prices plummeting to even greater depths.
That is one reason why the ratification of the TARP has had seemingly no effect.
There is no lender of the last resort in the European Union. Each member state is responsible for its own banking system despite being tied to the one currency – the now spiralling euro. France made an attempt on the weekend to launch a pan-European rescue package as it called together the leaders of the largest economies in Europe – Germany, France, Italy and the UK. The UK is a member of the EU, but is not part of the European Monetary Union, which has the euro as its collective currency. (Sweden is the other similar odd one out).
One of the reasons the summit was necessary was due to the actions of EMU member Ireland, which independently announced its intention to guarantee deposits in its banks. This drew the ire of Germany, as such actions are not meant to be taken in isolation, but Ireland was desperate. For years it has rebuilt a struggling rural economy into a leading European centre for banking and IT. Its economy is thus now in tatters once more. But when France put the suggestion at the summit that the Big Four economies coordinate a rescue effort of their own, it was Germany who baulked.
The German economy is the third largest in the world behind Japan and the US (China is now about equal third). It has a large surplus against the US deficit and is the European economic powerhouse. By contrast, many of the other EU member economies are in dire straits, carrying significant deficits. This has resulted in a large disparity in bond yields amongst the haves and have-nots within the EU.
That is another problem with the euro as a concept. The US dollar is supported via the US Treasury bills and bonds. The European Union has no equivalent. We are now seeing a “flight to safety” into US Treasuries which belies the absolute economic disaster looming in the US. The euro has no such support.
With Germany a dissenter at the summit, the leaders decided only to instruct each member state to shore up its own banking systems, guaranteeing deposits as necessary. Germany was not going to throw its own good money into bad elsewhere without control. This call was heeded by many of the members. The EU had failed.
Last night the Dow index fell as much as 800 points before buyers returned to spark a sudden and fierce rally. One impetus for the rally was talk that a coordinated global interest rate cut would need to be implemented as the only way to stop the dominoes. The US economy (or at least perception thereof) went first this year, and now it is Europe’s turn. The fact that the yen remains relatively strong is a reflection of carry trade unwinding only, for the Japanese economy is also on the precipice.
The Australian dollar has now undergone one of its most spectacular collapses since it floated in 1983. In June it was trading over US$0.98 and all talk was of approaching parity with the US dollar. Three months later and it has traded under US$0.70. The Aussie is taking a triple hit on falling commodity prices, expected rate cuts (now probably more than 50 basis points), and the panicked carry trade unwinding that the downward move itself sets off.
Panic is what the world is all about right now. A move likes the Aussie dollar’s only highlights the problem of a “globalised” economy being fractured into self-interested parties. For the dominoes to stop falling in an ever increasing succession of counter-reactions, one coordinated global effort must now be made. Only then can the “world” attempt to find some level of financial stability.
