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Saturday, February 14, 2009

Staring into the Abyss

By Claus Vistesen: Copenhagen

“If you gaze long into an abyss, the abyss will gaze back into you.” - Frederic Nietzsche

When you get that close to the abyss, you can always jump tomorrow.- Unknown

This beautiful Saturday morning in Copenhagen, I am reading the latest edition of the Economist and there are a couple of interesting bits and pieces I want to start with. First of all, the Economist runs a long piece on Irving Fischer and his debt-deflation theory. Since I am digging hard in the annals of economic history at the moment I find it a good read. Personally I am actually studying Fischer at the moment, not because of his debt-deflation theory, but because of his seminal work on the theory of the interest and how fundamental his work is in the context of economic modelling as they teach us on grad school.

Moving into the present, the Economist are none to happy about the Obama plan and bailout and call it too timid as well as a watsted opportunity. They are not the only ones who are drawing this conclusion. The Capital Spectator calls it big, bold, but vague, the FT's Martin Wolf also seems sceptical particularly with respect to the measures to shore up the financial sector, James Hamilton also seems most timid in his praise, whereas Paul Krugman pure and simple calls it the failure to rise (hat tip; Mark Thoma).

Perhaps those astute commentators above are jumping the gun a bit although I would have to say that I have not studied the plan in great detail. However, I agree on the banking side since what we need now is probably widespread nationalisation. Every bit of my liberal fiber is trembling by saying this, but the semi private market solution through re-capitalisation, with government funds à la Sweded, seems even more unlikely to work I think. Quite simply, it strikes me that the latter may be much more complicated than the former in terms of speed and thus, in the present context, efficiency.

With respect to the overall plan I latch on to Krugman's (and others') point that in the end it all turned into bipartisanship which is a pity. For example, I am certain that all those money spent on tax cuts are useless in so far as goes to remedy the immediate slump in demand. By all means, let us keep ideology out of this, but I think simple economic logic tells us that Ricardian Equivalence and the propensity to save (precautionarily as we call it in economics) are very high in this environment especially with unemployment rising by the week. And with respect to the coming steps of this crisis unemployment will rise much faster across the board than people expect. An anecdotal story from my home country shows this. My sister here works for a municipal unemployment service where she negotiates with businesses on behalf of "disabled" citizens who can only do part time work or certain kinds of non-physical work. Clearly, these people are getting laid off by the buckets at the moment which is making their life difficult. However, she is also reporting that each week her and her coworkers can actually SEE the lines grow at the more regular unemployment offices. Each Monday the line is just a little bit longer. This is almost 1930s soup kitchen style.

Finally, the Economist runs a long piece on Irving Fischer and his debt-deflation theory. Since I am digging hard in the annals of economic history at the moment I found it a good read. For my own part I am actually studying Fischer at the moment and especially his seminal work on the theory of the interest and how fundamental his work is in the context of economic modelling as they teach us on grad school. It is always funny to understand why it actually is we are being taught the way are, because I can tell you this is one thing which is painfully absent in modern teaching.

Mickey Mouse Numbers in Japan and Eastern Europe

With respect to the data, I am not sure whether to laugh or cry (although I am pretty sure it is the latter at the IMF and in Latvia). Actually, my first reaction when I saw two research snippets, sent around by some friends, on Latvia was to laugh. This is Mickey Mouse numbers folks! An expected 20% contraction here and 10% there. The actual numbers confirm this. Q4 GDP fell a healthy 10.5% in Latvia and 9.4% (yoy) in Estonia. This means that 2008 saw a contraction, in Latvia, of 3.6% which follows a 6.3% expansion in 2007. Now, how long was it that we had the discussion about a soft v hard landing in the Baltics? Ah well, I will refrain from commenting.

Further afield, the traditional survvey conducted by Bloomberg suggests that Japan may have contracted a full 11.7% (annualised) in q4 which, of course, is quite disturbing. Clearly Q4 was always going to be a shocker, but this is quite disturbing. As I noted in my last large review on the Japanese economy all gauges were pointing firmly down and it these numbers indicate that this is most definitely the case. Expectations have it that Japan may have contracted a full 3.1% qoq in Q4 which is just massive and really raises all kinds of questions.

Japan’s economy probably shrank 3.1 percent from the third quarter in the first set of GDP data made available for the period following the collapse of Lehman Brothers Holdings Inc., economists said. That would be almost triple the pace of contractions in other major economies -- the U.S. shrank 1 percent quarter-on-quarter and a report out this week is expected to show the Euro-zone GDP fell 1.3 percent.

As could have been expected and despite the BOJ's valiant attempts and determination to keep the corporate debt sector afloat the massive decline in economic activities is transmitting itself quite dramatically into corporate debt markets. The cost of protecting Japanese corporate bonds from default rose to a record as the world’s second-largest economy battles a worsening recession.

The Markit iTraxx Japan index of credit-default swaps on the debt of 50 investment-grade borrowers rose 25 basis points from Feb. 10 to 455 at 12:55 p.m. in Tokyo, BNP Paribas SA prices show.

“The credit profile of the Japanese corporate sector has deteriorated quite substantially in the past couple of months, and the situation could get worse even though companies are trying to cut costs,” said Yasunobu Katsuki, chief credit strategist for Japan at Mizuho Securities Co. in Tokyo.

So, what is going on here? Well, I will tell you what is going on. Without the benefit of growth in foreign markets Japanese companies simply have no future revenues to sell and thus no collateral against which to sell debt. And why is this you might ask; well because, absent a solid growth in exports, Japanese companies have to rely on the domestic market for growth (at least to some extent) and this is quite literally impossible with Japan's demographic profile.

In the Eurozone, the Noose Tightens

Turning to my home turf in the form of Europe Eurostat published the the initial estimates for Q4 GDP and boy does it look ugly. Edward dishes up all the important arguments and data points; on Italy, Spain and Germany. Needless to say that the aggregate picture is reflective of this as GDP in the Eurozone contracted 1.5% over the third quarter and as a result analysts and commentators are pulling out big doom and gloom brush on this one.

Kenneth Wattret who is a senior economist at BNP Paribas simply noted that the news was dire and dished up the thump of a forecast that we are going to see three consecutive quarters of contraction as well as a huge rise in unemployment. Over at Illuminati, Jim O'Neill noted rather smugly that the downturn is worse in Europe than in the US which, given the fact that the whole thing started in the US, is quite an achievement as he puts it. In terms of economic dynamics the Eurozone is being hit by a severe slump in domestic demand as well as a sharp decline in global and intra EU27 trade volume (yes, my dear reader, the East-European connection is important). Add to this that governments in the Eurozone are pretty much out of bullets at this point as well as the fact that the ECB refuses to fire offs its, albeit timid, remaining slugs and the outlook is grim and nothing but grim.

How to Deal With That Abyss then?

I could go on and on dishing up one scary market report after the other (believe you me, I could!). However, it will suffice I think with a reference to Brad Setser's recent installment in which he simply notes how how this is now a truly global slump. As I have argued endlessly and as I try to sketch out in the context of global imbalances here and, more wonkishly, in the context of protectionism here we need to look at the export dependent economies why they have this characteristic and what it means. Brad Setser thus gets to the heart of the matter when he says;

It consequently is striking to me that the countries with the steepest falls in output in q4 have been the countries that are known for relying heavily on exports for growth –

They in effect are suffering from a sudden stop in global demand, which has given rise to a sudden stop in trade flows. Or perhaps a sudden stop in finance led to a sudden stop in demand, a sudden stop in trade and sharp falls in output.

For me it is not so striking, but then again I suspect it is not for Brad either because he, for one, has been breathing down Asia's neck with respect to the region's growth path. On this background, it is naturally presicient to ask what the hell to do? It has been clear for a while that Q4 data both corporate and macroeconomic would point to a severe slump and whether you are surprised or not is really not relevant at this point.

Going back to my initial remarks I will consequently end this on a reflective note.

It is true that in every recession the old adage "there is nothing to fear but fear itself" has some meaning. Psychology and (rational?) expectations are a wonderfully complex set of mechanisms really in relation to economics and it is obvious how, in the current environment, people can easily get very afraid of their own shadow. Better not to look in that abyss then it seems, and try to look elsewhere, perhaps outwards across the horizon towards better times. I would certainly hold that this is fundamentally a sound way to live your life and look at the existence of us all as we engage in those famous economic transactions (without going into a discussion of what FN really meant by this).

However, sometimes you also need to engage the demons which are looking back or more specifically; sometimes it is dangerously complacent to assume that one will actually have the opportunity to jump tomorrow. Tomorrow the chasm might have widened and you find yourself tumbling down towards the bottom. I remain fundamentally certain that we will jump as a global economy, but I sure hope that we won't loose too many to the abyss in the progress.