by Peter Boone and Simon Johnson

The US government has moved dramatically, in what it argues is a comprehensive manner, to counteract serious problems in the financial system, and to reduce the risk of a serious recession or worse.  Eurozone policymakers are far more reluctant to intervene.  They remain inclined to handle growing bank failures on a case-by-case basis; and, while their central banks have provided liquidity, they have avoided using other fiscal and monetary policy tools.  If the fortunes of the world economy depended only on the US policy response, we would predict just a fairly severe recession.  The absence of any indication that there will soon be a decisive European policy response suggests we could be in for something considerably worse.

In the view that is increasingly prevalent in the US, we are not facing a Keynesian demand recession, nor the supply side shocks of the 1970s. It is a crisis of confidence very similar to the Asian crisis of 1997-98.  The lesson from these events is when trust in highly leveraged financial markets weakens, there can be long and enduring repercussions across all sectors of the economy. The Federal Reserve’s implicit policy model since September 2007 appears to be tied in part to those events.

In contrast, the frame of reference for European authorities appears to be drawn from the lessons of the 1970s.  They are concerned about inflation and second round effects from past commodity price rises, so they keep interest rates higher.  They have not announced national programmes to bail out financial institutions and borrowers, in part, because of perceived costs relating to future moral hazard.

Today, markets and events are judging the Federal Reserve closer to being right over the past year, and the European Central Bank, ECB, (to a lesser extent the Bank of England, BoE) almost definitely wrong. A major global recession is predicted by both equity and credit markets.  The Dow Jones US Basic Materials Index has fallen 32 per cent since the end of August. This index reflects the future profitability of basic materials producers, and so predicts a major decline in commodity prices.  The price-earnings ratios of European and UK stocks, now near historic lows, are only reasonable if we believe a major earnings recession is upon us.

The rise of credit default swap (CDS) spreads, especially for the financial sector, since May has predicted the recent rise in bankruptcies.  According to swap markets, more bankruptcy across many industries is to come.  The market-implied probabilities that major banks, such as Barclays, RBS, and UBS will go bankrupt within five years have each risen by almost 15 per cent since May 2008.  Time and again, over the past 15 months, CDS spreads have given us an accurate heads-up on where cracks are appearing in the global financial system.  The signals from this market now are unmistakable.

These changes in market pricing, matched by recent events, should be alarming to policy makers in Europe.  European policymakers have consistently underestimated the coming difficulties.  Their baseline forecasts were revised down only recently, and still suggest at most mild recessions.  When interbank markets first tightened, the BoE was hesitant and last to step in to help.  In April, when the IMF published a detailed report using market data to estimate that losses on mortgage-backed securities alone would amount to $1 trillion, the BoE quickly replied that their own models indicated this estimate was far too high.  On this specific point, the BoE proved quite wrong to think it knew better than the market.

Let’s suppose markets are right again now.  Because we are falling fast into a global credit crisis, inflation is not a serious risk. Despite the perverse but short-lived increase in commodity prices this year, we will now see sharply falling prices. Across most countries in Europe we will see sharply falling housing prices.  Companies are now reducing investment and spending plans due to the high cost, or lack, of debt and desire to build cash balances.  Today’s weak unions will not have bargaining power in this environment; workers will not want to risk losing their jobs when faced with negative equity in their houses. There simply will not be room for workers to demand high wages nor companies to pay, and hence a wage price spiral as in the 1970s is most unlikely.

It is ironic that Europe’s policymakers are sticking with a frame of reference from the 1970s, because during that decade policymakers also, arguably, used the wrong model: they expanded the money supply hoping to win recovery, but instead generated inflation.  Nations lost essential confidence in their leadership when it became clear they could not manage the macro environment and they had the wrong recipe to cure it.  A loss of trust and credibility helped ensure the 1970s recession was deeper and more protracted than necessary.

In today’s environment, European policymakers are making three regrettable and avoidable mistakes.

First, by keeping interest rates too high, the BoE and ECB are running a type of unsustainable pyramid scheme with their citizens and banks.  The main collateral behind the bulk of loans is real estate, which is already sharply declining in many nations.  Soon, as unemployment rises and the economy contracts, delinquencies and foreclosures will rise sharply.  Arguably much of the banking system in some European countries (notably the UK) is already insolvent or has far too little capital (as has appeared in important parts of the eurozone over the past week).  When the real economic impact begins, it will get much worse.  And, today’s high interest rates means there will eventually be even more debt to restructure.

Second, especially outside of the UK, there is an obvious lack of planning to deal with the many more banks that will be declared insolvent and need some form of support.  Iceland’s Prime Minister summed it up yesterday when he said “Now it is every nation for itself”.  The recent announcement by Alisdair Darling that the UK is preparing major measures is a relief, especially after the European leader’s meetings on the weekend failed to agree on any specific coordinated actions.  The risk now, of course, is that disparate actions such as Ireland’s blanket guarantee of deposits, could lead to harmful competition across nations.

Third, Europe is making a serious error by focusing on moral hazard during a systemic crisis.  During a systemic crisis, the allocation of capital becomes enormously distorted by the need for liquidity, so we should put primary emphasis on ending the flight to liquidity that is causing damage.  Solvent institutions will fail if they cannot gain access to credit, and the resulting bankruptcies and liquidations have large economic costs.  This is a shipwreck; if you come upon the Titanic sinking, save everyone you can and deal with the effect on shipbuilders’ incentives later.

It is time for the authorities in Europe, including the UK, to take two clear actions as a package of measures to stop the coming decline:

1. The ECB and UK’s MPC need to present a clear forecast for inflation, under a scenario reflecting market forecasts, to illustrate the likely path of the economy if markets do prove correct.  We have little doubt that such a scenario would warrant an immediate (this week) 50 basis points lowering of rates throughout Europe, with more probably needed quickly.

2. Europe needs a coordinated plan to recapitalize nearly all its banks.  The recent announcements by Alisdair Darling sound highly encouraging in this regard.  However, if implemented, it will put British banks at a clear advantage to highly leveraged continental banks, so Europe needs to follow suit.  Capital injections should be adequate to withstand a severe global recession.   The experience of Asian crisis was that such measures could help, but are no panacea.  Once bitten, creditors and borrowers will be slow to return to normal.  We will almost surely have a serious global recession in the coming year – we need policy makers to rapidly update their mental models to prevent even worse outcomes.

Peter Boone is chairman of Effective Intervention, a UK-based charity, and an associate of the Centre for Economic Performance, LSE.  Simon Johnson is a professor, MIT Sloan School of Management, and a senior fellow at the Peterson Institute for International Economics.  They update their views on the crisis at http://BaselineScenario.com.

Tags: Bank of England, UK economy, US economy

October 7, 2008 4:19pm in Eurozone | Comment