Where to next

Following on from my previous post, and, after noting approval of the $700 billion rescue package, the question arises ‘where to next?’ The Rescue package itself will not materially have any effect for several months and in the meantime gloomy economic news will dominate commentaries.

So we witness the NY stock exchange emulate a series of ‘dead cat bounces’ which are quickly soured by woeful economic news such as 159,000 jobs lost last month, capping off 9 consecutive monthly reductions.

The Government has also admitted the economy in the USA is in recession, evidenced by 760,000 jobs lost so far this year. Its contagion spreads to overseas markets captive to this continued gloomy sentiment and building in expectations of a severe downturn.

In fact in a sample of the 88 largest economies the USA is ranked 22nd in terms of market indices, ahead of countries like Australia whose economies remain resilient and well regulated according to the International Monetary Fund. But markets are driven by sentiment not logic and panic sellers build in future reserves of anticipated gloom and doom, to cause minor apoplexy over here since most retirement schemes for all workers are generally heavily market linked.

We continue to see markets and consumers rattled and worried about a run on the banks simultaneously in many different countries. I notice Germanys Finance Minister Peer Steinbrueck has announced an unlimited guarantee for all personal savings and checking accounts. It was designed to win back confidence as the global financial crisis spreads and equates to about $1 trillion. A moral hazard? bear in mind that perhaps in that country it was too much of a reminder of those similiar events of the great depression; run on the banks and unrest that enabled the Nazis to come to power.

Hopefully all of this interventionist’s actions should help avoid past mistakes such as what happened to Japan in the 1990’s. Japan's reckless lending during the eighties led to the Asian crises but its Ministry of Finance failed to intervene. Many thought its banking system was insolvent, but the Banks refused to acknowledge their portfolio of non performing loans and write off the bad debts. What followed was an unnecessarily long period of vicious stagflation, which saw a 3 fold increase in unemployment and misery with property prices reduced by 70%, until it finally recovered a few years ago.

What can be done?

There is no short term fix but I think sensible measures could see a gradual improvement to avoid a fully blown deep recession. The curent crisis provides a catalyst for a systemic change to a better regulated and transparent financial services section, rejected by either political party over prior decades.

What is currently plaguing the system is the scarcity of credit as world wide deleveraging unhinges the ability to continue to trade on the diminished capital base. Overnight facilities, which are the only facilities available to many, are rolled over each day to have a destabilizing effect combined with severe illiquidity as others hoard previouly available cash in the climate of fear.

The $ 700 billion rescue package will help alleviate this unstable situation gradually and help secure more long term facilities underwritten by the improved Balance sheets once the toxic debt is removed. The amount of debt removed should 3/4 times the original value, since the securities to be disposed of through the reverse auction system will be at a fraction of their original value. Bear in mind the same amount has already been written off

So in total in round figures you are eliminating about 6 trillion in value. No small beer!! although this still only represents a fraction of world liabilities. However we should not include derivatives which have a zero sum outcome, (a buyer and seller of an outcome attaching to a security which cancel out to zero if they were simultaneously collapsed) in assessing the extent of these liabilities.

What does remain however is a diminished capital base to undertake the herculean task ahead and hence more help will be required from Central banks and from holders of cash and government securities to invest.

Although Central Banks throughout the world have given the impression they are improving liquidity by increasing the total money supply, official figures indicate this is clearly not the case. The reason they have not acted is out of fear such action will ignite inflation, particularly with loose worldwide monetary policy represented by average inflation of 5.5% versus official interest rates average at 4.5%.

However with weaker demand and a recent hefty fall in commodity prices including oil I think there is ample scope for further easing and injection of much needed liquidity, to coincide with reduced world wide inflation. The easing will mainly be at the behest of those economies outside the USA, to additionally include accelerated technological transfers of expertise to improve employment prospects.

What I also think needs to be done is a further reduction in interest costs to ease the burden with taxpayers on mortgages and on commercial loans. This will be appreciably easier as the inflationary outlook becomes more benign. The spreads that currently exist between the borrowing cost of Freddie and Fannie (Government treasuries and mortgage rates) give ample scope for reduction in interest rates.

So far this year there have been over 2 million foreclosures so it makes sense for these service providers on behalf if their security owners to be more flexible and proactive. Significant progress over and above the 400 000 targeted for help should be possible.

The rebuilding of the USA capital base will require infusion from overseas. This will not happen until Investors are convinced of a more transparent and improved regulatory system. Nether party has announced what it will involve, other than talk about the need for an improved single regulatory authority. Once this happens overseas investors I think will be persuaded to part with their equally hard earn money to invest in the USA.
It should be welcomed as it will add stability and diversity.

Finally from a political point of view there is a need to harmonize respective economic policies between countries, an urgent requirement for the incoming incumbent to the white house.

We are one global village; one that is currently devastated by a tidal wave of worries but can refloated with agreed sensible policies and to avoid the mastakes of the past.

The USA as the world largest economy, with 25 % of worlds trade needs to work with its partners to regulatory reforms and improved economic ties as priority for its hard working citizens and those who are equally affected overseas if we are to avoid a deep recession.