by Claus Vistesen: Lausanne
As the horror story of financial markets continues at full speed it may seem a rather futile endeavor to try to make sense of what is increasingly becoming senseless by the day. Yet, you hardly need to be a financial literate to see that the world of finance and banking has been changed for good. I don’t think this was neither unwarranted nor unexpected. At some point, US authorities had to let someone on the Street fail and it turned out to be Lehman (with Merril Lynch of course coming close in behind as it was snapped up by Bank of America). AIG on the other hand was saved as their role as insurer was deemed too important and systemic to merit a collapse. Then we have Wachovia, the Washington Mutual Trust etc etc …I can understand if many will have a hard time gauging the playbook through which regulatory authorities decide who lives and who dies. As we learned this week that Paulson’s plan was not passed by congress the downside now resembles something of an abyss. It will be interesting to see what happens as the bail-out plan makes its second tour to congress.
Since rumors began of the peril of sub prime mortgages and credit crunch became the new buzz word in the financial vocabulary we have seen some quite eventful weeks not to mention days in which volatility has gone far beyond what any respectable VAR model would be able to foresee. Still the past two weeks must clearly take pole position so far. The numbers flying around and the movement in key market parameters have been extraordinary. That equities were down should not surprise us as we have seen it before this year when Wall Street’s office buildings have been re-shuffled. However, this time it was perhaps a bit different as yield on treasuries fell to almost 0% at one point as investors quit anything with but a faint smell of risky assets. Another specific and most unwelcome side effect of this was the corresponding seizure in credit and liquidity markets which followed. At some point, the cost of borrowing money in the interbank market almost doubled taking the LIBOR rate close to 650 basis points (now running at about 550 bps on the back of the échec of the Paulson plan) as well as the three month spread of LIBOR over the treasury climbed to over 300 basis points. These swings tell an important cautionary tale of the seriousness of this crisis. Especially, the lack of confidence and subsequent seizure of the short term financing market is one of the most tangible and severe effect from this crisis.
Meanwhile and beyond the immediate eye of the storm on Wall Street, Europe is entering its own house of pain as cracks in the banking sector begin to steadily emerge. Add to this that the macro environment is pointing towards a steep Eurozone wide recession and you have the ingredients for a very serious downturn on the European continent. I still hold that the lack of real response on the rate front will not only hurt the ECB’s credibility, but also worsen the inevitable slump.
In emerging market land, things are not looking brighter with the anticipated safe haven flows drastically eroding valuations of asset markets in these economies. Russia seems to be suffering more than most from the recent retrenchment of risk aversion. Now, before people let their thoughts wander back to 1998 and LCTM’s spectacular collapse betting on the wrong side of the Russian debt binge I don’t think that Russia stands before an imminent default. Around $700 billion worth of reserves in the form of foreign exchange and national investment vehicles will keep Russia from any kind of immediate default. However, with trading in the USD denominated RTS index halted twice during the last two weeks due the continuation of outflows from foreign investors, it is difficult to ask the subtle question of whether this time, it might not be a little bit more serious than mere tremors  .
On the back of yesterday’s news that congress rejected the bailout plan knitted together by Paulson and Bernanke, the MSCI World Index of 23 developed markets dived 6.8 percent, which was the sharpest decline in the measure's 38-year history according to Bloomberg. In Brazil trading was suspended after the Bovespa fell more than 10% and in India and aforementioned Russia equities were equally pummeled. Stephen Jen and his colleagues from Morgan Stanley (who itself is fighting for survival) have some interesting points on capital flows to emerging markets in the latest edition of the GEF.
What happens next is of course anybody’s guess, but below I would like to point to one plausible and tangible outcome of the wheels that were set in motion back in august 2007 when BNP Paribas announced subprime related losses and thus took the credit crisis to global levels.
Deflation as the Next Macro Story?
The macro themes which have characterized the past year’s eventful period have been fickle. As the Fed decided to let interest rates fall in the end of 2007 decoupling was the name of the game as gold and crude oil reached new highs at one and the same time as the USD was pummeled. However, as it became clear that the US was merely the proverbial canary in the coal mine for a much wider global slowdown the sentiment changed. One main question in this regard was always whether the obvious bout of stagflation, at some point, would turn into deflation; a question I also mused on a couple of months back. As per usual with these things there are arguments for and against. The strongest impediment to a worldwide deflationary slump is the continuing pressure from growth in emerging economies. To be sure, these economies are also going to be run down a notch, but the underlying momentum and the lack of global supply slack in terms of energy resources seem certain to keep headline inflation high as we move forward.  However, the crucial point here is exactly that the double barril of imported cost-push inflation at the same time as the economy is contracting may lead to a negative feedback loop that can provoke deflation. Consequently, when I look at the current deterioration in real economic activity across OECD as well as the ongoing tensions in credit markets I believe that deflation is now a fair and probable call in the context of key regions and countries.
Essentially, it is difficult not to notice that something has changed with the recent stream of incoming macro data for Q2 and Q3. In Europe, the Eurozone and key parts of Eastern Europe are likely to be in a recession and also Japan seems to have hit a brick wall. Meanwhile emerging economies also seem to be slowing sharply although recessions in that part of the economic edifice are very unlikely.
All this almost looks like de-coupling in reverse, but the US is unlikely have to have seen the worst yet. Re-coupling does not only work one way and just as the US has enjoyed a windfall from exports in H01 2008 so will the rapid deterioration of the rest of the world feed into US growth rates. It is important to note here that the US’ capacity for domestically induced growth is next to none with a consumer saddled with debt and a financial system in shambles. The US has not yet posted growth rates akin to a recession  but that will most likely happen as we come closer to 2009 (Q4 08 and Q1 09 would be my guess, but do go have a look at MS’s Berner and Weiseman for a one stop look at the US economy). In the briefest of versions this small view across the global economic edifice indicates that activity is coming down sharply across the board. In many ways, the effects on the real economy are only about to emerge as we move forward from here and this will be accelerated by the ongoing tensions in financial markets.
However, a sharp de-accelerations in activity need not lead to deflation and even if it does it may, according to some, be the only meaningful end result as well as means for correction for some countries. This begs the question of why am I invoking the deflation ghost and, more pertinently, what kind of deflation I am talking about?
In many ways, the current decline in real activity makes perfect sense as it comes on the back of an extraordinary run in terms of the economic cycle. Some are even talking about the end of one big mega-cycle with some debate on when this cycle is supposed to have started. I will leave this question neatly aside for now and merely conclude that with the added flavor of credit market turmoil and the velocity of the cycle that was (and is now gone), this present slowdown and crisis seem, in many ways, to be quite different than in previous global downturns.
To state that things are different however is scarcely enough to determine whether some parts of the global economy are headed for a sustained deflationary spiral (save perhaps for Japan, but I will touch on that below). However, I would still submit the claim this is actually a real risk at this point. In the following I will argue why.
Stating the Obvious
One key element in my call is a statement of the blatantly obvious. The credit crunch is consequently not just a figment of imagination but a real phenomenon with subsequent real and measurable effects, and what we really ought to be asking ourselves is what it actually means? An almost endless amount of commentary has been devoted to the answer of this question, but I still think that we should try to have a closer look for the sake of argument.
If we begin from the point of view of asset prices, I believe most people can agree that the world as a whole has now entered a prolonged period of asset deflation in key sectors. If we look at an asset such as real estate and housing it seems clear that a substantial amount of deflation lies ahead for many economies before previous imbalances can be corrected. Given the strong and accentuated wealth effect from real estate appreciation due to the possibility for equity withdrawal this is one of the main ingredients in the current crisis. In fact, if we peer across most economies who are now facing serious corrections real estate bubbles was an integrable part of past exuberance.
As regards financial assets we also seem to be in for a period of deflation even though the volatility of such movements makes this an entirely different beast. However, it is interesting in this respect to observe that whole classes of financial assets that were hitherto used to prop up many a financial institution’s balance sheet have now been completely evaporated. This is true not least for many credit products as well as it seem that many debt products backed by mortgages are heading for oblivion (the fascinating tale of the Spanish Cedulas here is a good place to start).  In this way, it is perhaps not so much a question of deflation in financial assets but more so about a process by which the asset base is narrowed. I do think this is a critical point to take aboard. This is not just about wealth destruction because risky assets fall in value; it is also about the destruction of entire asset classes and financial business models. If we add to this the general tightening of credit and liquidity provisions we end up with a massive and abrupt shrinkage of the global credit base.
Many would see this as a good and indeed quite necessary byproduct of the incoming slowdown. The past economic cycle was one of easy money and an unprecedented expansion of the credit and liquidity base through, not only through leverage, but also through simple product innovation in the context of financial products. I agree with this narrative, but there is more to this story than meets the eye.
What Does it Mean in a Macroeconomic Context Then?
Two things are important here I think.
One the one hand, economies that have been living well on foreign credit will now have to revert to a different or less extreme version of their previous growth path. Countries such as Spain, the USA, Australia, New Zealand, and many emerging economies in Eastern Europe are amongst the major candidates here. In general, it is clear that across the entire global economic edifice external deficit economies will need to tighten their belts due to the widespread global slowdown.
On the other hand, we also need to look at the credit side since this is not only a story about excessive exuberance on the part of debtor nations. It is also very much about the creditor economies and how they have been living high on foreign economies’ willingness and capacity to absorb the inflows. Now that the capacity for credit absorption is declining, so will creditor nations loose momentum as they are no longer able to tap foreign debtors to the same degree as before.
It is especially within this context that I see the potential for deflation. In particular, I would cut a lateral line through those creditor and debtor nations with distinct demographic profiles in the form of low fertility rates and subsequent high and rapidly rising median ages.
On the credit side Japan and Germany stand out as obvious candidates  . We can already see from the data how, absent support from external demand and asset income, headline GDP figures are tanking. Given the persistently depressed situation with respect to domestic demand and the deteriorating global credit conditions, there is a real chance that whatever endogenously generated trend growth path these economies can muster, the ensuing price trend could very well be one of deflation in core as well as key asset prices.
Turning to the deficit nations many commentators have noted how the US may be entering a Japan type of lost decade. I still think this is very unlikely; the amount of liquidity being pumped into the system as well as the much more stable demographic profile will prevent the US from falling under the yoke Japan did in the 1990s. However, I need to concede that the continuation of negative real interest rates at one at the same time as the public debt is being used to funnel corporate’s and household’s liabilities are not helping the US debt position. Without a shred of doubt, the US economy is hit much harder than was initially anticipated and at this point in time it remains to be seen whether the aggressive regulatory arrangements will have the wanted effect. In a more fundamental light I think it is quite obvious that the role of the US economy will change for good which need not be a bad thing but will take some adjustment of mindsets.
Meanwhile, I do see considerable potential for deflationary corrections in Spain, Italy and key parts of Eastern Europe. My rationale is that these economies perhaps stand before the most severe adjustment of all. In Spain the structural break is obvious. 6 years worth of housing booms, deficit spending and high growth driven by massive immigration and negative real interest rates will now need to be corrected. The rub here is however that membership of the Eurozone and a fixed exchange rate make wage deflation almost a certainty if a correction is to be achieved. Coupled with the unraveling of the housing market the downward momentum is extreme, and it should never escape our attention that before 2000 Spain was set to become to oldest society on earth. If she is not able to keep those immigrants the ensuing negative shock to the labour market will be quite severe.
In principal the same argument can be applied to Eastern Europe where the recent period of violent inflation may very well be the initial stages to a slump where wage deflation is the only possible way to correct in light of fixed exchange rate regimes. The greatest threat is that the slowdown becomes so severe that emigration intensifies further. This would have quite important consequences for these economies’ already distorted demographic profiles. One obvious question is the extent to which a prolonged period of wage and asset price deflation would be politically palatable. I would seriously doubt this and then we are back in the viper’s nest where the potential for an abrupt rupture of the Euro peg as well as a severe funding crisis à la Asia 1997.
As for Italy, it has long been my standing position that Italy, at some point, could tumble into a Japan like deflation trap. Whether it will happen during the turn of the current cycle is debatable, but the severity of the slowdown certainly suggests that the possibility is a real one. In passing, I would like to note that the issue of Spain and Italy (and quite possibly other economies in the Eurozone too) will not make life any easier at the ECB and in Bruxelles. The point here is simply that the ECB would not, under the current regime, be able to administer some local version of the Japan ZIRP in Italy and/or Spain. The consequences of this inability may unfortunately now become clear for everybody.
The main manifestation of the potential deflationary correction will be through wage deflation (especially in real terms) as well as a persistent gap between strong headline inflation and core prices. This is an undercurrent in the data I have been highlighting persistently in my analyses. The key point to latch on to is the inability of some economies to muster domestic demand which in turn will tend to have a deflationary effect; especially in the context of an incoming slowdown as we are seeing now.
Much Ado about Nothing?
If you have made it this far, you might ask with some legitimacy whether in fact I am not making much ado about nothing. After all, the means for correction here are pretty standard econ 1-0-1 type processes and deflation need not be an unwelcome thing as long as there is light at the end of the tunnel.
My main thesis however is that many of the economies which now face potential deflationary corrections do so principally because of their demographic profiles. If past experience is anything to go by this should raise more than a few eyebrows since we know how difficult it is to escape from deflation once you are caught in the web. This is the ultimate lesson to draw from Japan’s so-called lost decade. It was never exclusively about incompetent Japanese policy makers. Rather, the crucial question to ask is why Japan did not manage to muster sufficient domestic demand to recover and why Japan is now completely dependent on foreign demand and asset income to attain respectable  growth rates.
I believe that the answer to this question resides within the sphere of demographics and it is in this light I am worried that the global economy will see a number of economies join Japan (Germany already has I would argue) on the back of the current crisis.
If this turns out to be true it also highlights a number of crucial questions. The first is simply that if many hitherto net credit absorbers are now to become to net credit suppliers where is the extra global capacity going to come from? From my chair, it is as if everybody is talking about the need for the US to export its way out of trouble, but who the heck are going to take up the slack? Moreover, if I am right in the sense that many former deficit nations have suffered a structural break the re-shuffling of the global economy will not lead to a more balanced flow of funds, but rather the opposite. This would especially be the case if key emerging economies persist on maintaining an open life support to whatever is left of the Bretton Woods II system.
Another way to narrate this predicament would be to ask who will do the saving and, equally as important, who will provide yield for the accumulated stock of capital?
As for the first part of the question one is tempted to say everybody. External deficit nations will now have to work towards grinding down the debt and external surplus economies cannot, for the most part, do much but to cling on to the increasingly smaller batch of growing markets. I am still skeptical here that the unwinding of the Bretton Woods II à la traditionelle with China and Petroexporter et al. holds much promise to bring rebalancing. As for the part of the world actually able to act as buffers (e.g. India, Brazil, Turkey etc), they are clinging on with their nails, not only to prevent a rout on their capital markets as money pours out, but equally so in the context of actually absorbing the flows once the money start coming in again, because trust me, it will. The key point in terms of global capital flows is that the margins are simply getting smaller in terms of living off of one’s accumulated savings (assuming of course that you do not dissave) and that this will hurt economies in the old end of the demographic spectrum in particular.
In conclusion, one of the main forward looking macro themes I am watching at the moment is the potential for deflation. I would especially ascribe this risk to be high in economies in need of serious competitive and debt reducing corrections as well as in economies unable to muster sufficient domestic demand to stay above water when external demand falters. In my rudimentary analysis I use demographics as a yardstick and as such my claim is quite easily falsifiable. The only thing we need to do then is to watch and see what happens.
 My colleague Edward Hugh does just that, and I recommend you to go have a look.
 Even if it may turn negative y-o-y in 2008 on the back of the accelerated slowdown.
 Although most would agree that the US is now firmly in a recession based on the commotion in financial markets and the deterioration of the job market.
 The very aggressive expansion of central banks’ balance sheet and the de-facto ability of financial institutions to offload assets on to ”public” books will be an interesting case to gauge for economic policy makers and historians alike.
 Japan has obviously never actually escaped deflation.
 Respectable here can mean many things, but one simple derivative is the extent to which Japan need a certain degree of headline growth in order to keep on servicing its liabilities.