By Michael Spence

The accelerating asset deflation globally is going to cause a deep global recession. The deleveraging process is driving emergency sales of assets, capital hoarding and asset prices (including exchange rates) to overshoot any reasonable estimate of intrinsic values.

Forced asset sales are causing damage to financial institutions, businesses and households that is to some extent irreversible. Currencies in many developing countries are plunging as capital is withdrawn to shore up balance sheets in advanced economies. Dollar denominated liabilities rise and the distress spreads, further accelerating the withdrawal of capital.

These strong headwinds are being experienced globally. There are numerous accelerators in various parts of the global capital markets whose operation is likely to produce a huge downside overshoot in asset values, including in economies where the problems are not more significant than a global growth slowdown.

The fundamental problem is there are few if any intrinsic value investors prepared to step forward at this stage. The reasons are understandable. In market freefall it is risky if not foolhardy. The result, if left unattended, will be an asset deflation that goes well beyond what is necessary to restore realistic values to assets. Overshooting risks major collateral damage in the global economy. This is a classic coordination problem in which value investors need a trigger point to enter the market.

In addition to the interventions (already under way) to insure credit availability to credit worthy borrowers, the efficient functioning of the payments system, and the injections of capital to begin to recapitalize banks, a set of coordinated actions are required domestically and globally to prevent excessive damage from a downward spiral in a full array of asset prices, a spiral driven by collapsing balance sheets and technical factors related to them. These actions involve governments and the private sector and need to be coordinated in a credible fashion and done simultaneously.

First in large a number of countries, direct intervention in the housing and mortgage markets as outlined (in the case of the USA) in TARP is required, via the purchase and efficient disposition of mortgages. This requires public funds. The interventions will vary across countries as a result of varying housing market conditions and mortgage contracts. The fact that TARP was and is not either fast enough or sufficient to deal with the expanding crisis does not mean that a program with its basic characteristics and goals can be set aside, in the USA and elsewhere.

Second, developing countries are now experiencing increasingly frequent credit challenges and the threat of lockups. This is the result of the rapid exit of capital, the causes of which have nothing to do with inherent strength of the domestic economy. The governments in developing countries need to intervene to restore the availability of credit using the government’s balance sheet.

Third, the rapid exit of capital from many developing countries has caused sharp declines in the value of currencies, causing dollar denominated liabilities to rise. Fearing a loss of external purchasing power, a further exodus of domestic capital accelerates the spiral. Countries with adequate reserves need to intervene to arrest the process. To substantially augment this type of intervention, the IMF needs to assemble funds from the developed countries and the major holders of reserves (Japan, China and the Gulf States), and use them to inject capital into developing countries. They should buy short term government securities in the domestic currency and the local government should make sure additional channels are open to get replacement credit funding to the private sector.

Fourth, companies that have intact balance sheets and stable long term prospects should start a program of buying back stock. There are many very clear cases where the medium and long term value of the equity is well above the current market price. Companies should be encouraged to undertake these programs together and with a clear understanding of the complementary actions being taken by other companies, governments and the IFIs. Large private investors and SWFs should be encouraged to participate sooner rather than later.

Fifth, in the USA, and perhaps elsewhere, a high-job creating program of investment in socially useful assets like infrastructure needs to be announced and committed to. To avoid being self-defeating in the capital markets, such a fiscal stimulus needs to accompanied by a credible and detailed plan to resource fiscal balance over a five to seven year period.

This set of combined interventions, undertaken simultaneously, has a reasonable chance of limiting an overshoot in asset value destruction, reduces the risks associated with a return of private capital to the capital markets, limits the damage to the developing world associated with a capital vacuum created in the US and the other developed economies. Most importantly it has the potential (when combined with the interventions already undertaken) to limit collateral damage globally.

The stakes are very high. The financial crisis has created an oxygen starved atmosphere in the global asset markets. Allowing their values to whither will further sideline the consumer, spread and deepen the recession, and create a level of distrust of the global economic system that will be hard to reverse. This is a classic coordination problem. Global asset prices and currencies are being set by forces that have little to do with economic fundamentals. A concerted asset purchase program going well beyond mortgages and involving multiple institutions is needed to reset the dynamics and to begin to set the prices on a realistic long term value basis.

Michael Spence is a senior fellow at the Hoover Institution and Philip H. Knight Professor Emeritus of Management in the Graduate School of Business, Stanford University. In 2001, he was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to the analysis of markets with asymmetric information.

October 27, 2008 2:03pm in Credit squeeze, Currencies, Economists | Comment