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Tuesday, December 09, 2008


the pessimist's case

something disturbingly like universal agreement on the probability of a rally in both credit and equity has emerged in recent weeks. even i am more optimistic in the near term. dissenting view is suspiciously hard to find, in fact, though nassim taleb does well -- and suki mann at socgen is also suspicious of the call for a credit rally.

[W]e don’t see a marginal bidder come in to help spreads go sustainably tighter. Still, the tremendous carry and breakevens means the many investors are content to add risk at these levels (and for spreads to remain wide) as long as default fears remain low.

risk premia remaining so large for the forseeable future is terrifying news for corporate borrowers. as graham turner of GFC consulting explains, skyrocketing corporate debt costs will mean phenomenal growth in joblessness is all but baked into the cake -- that it is now likely too late to prevent a deflationary depression.

The US unemployment rate could surpass the 1982 high of 10.8 percent by the end of next year. And it will carry on climbing, possibly reaching 15 percent or more by 2010.

The resulting social upheaval will pose a grave challenge for Barack Obama’s incoming administration. But the paucity of his economic strategy should concern us too.

Obama’s plan is heavily influenced by Lawrence Summers, the former US treasury secretary. It amounts to little more than a rehash of the post-war “Keynesian” consensus that failed to resuscitate Japan’s economy in the 1990s.

Increases in public spending or tax giveaways will not solve the core problem, which is how to stop borrowers from defaulting.

In 1932 the Federal Reserve drove interest rates down aggressively, which helped turn the tide. Corporate borrowing costs fell. It was still not enough – but it was more proactive than the botched policies of today.

By the time the Obama camp realises the error of its ways, even the more radical policies of the 1930s may well be insufficient. Interest rate controls, unparalleled intervention and a state of emergency may be the belated response to stem the slide into depression.

and that is indeed the jist of the correlation shown in this BoA chart courtesy of the ft.

Either: the market is broken; or we’re looking at a coming default rate spike more severe than that seen during the Great Depression.

and this is at a time when an ever-greater slice of american non-financial companies are joining the ranks of the junk issuers.

as noted by michael panzner, the economist also picked up on this theme.

It is not panic stations yet. Most firms can survive for a while with the credit tap turned off. Analysis by Moody’s, a rating agency, shows that the vast majority of highly rated companies in America and Europe have enough headroom, in the form of cash and undrawn bank facilities, to be able to survive for 12 months without needing new financing.

For now, an uneasy truce exists between most companies and their lenders. ... But hard choices are looming.

As the economic news worsens and profits dive, more firms will be at risk of breaching covenants ... Furthermore, a good deal of debt will fall due in the next few years: Reuters Loan Pricing Corporation, a data provider, estimates that more than $1 trillion of loans will need to be refinanced globally in each of the next three years, mainly in America and Europe.

Competition for capital is bound to increase in that time, given the coming torrent of government-debt issuance. ... With little obvious benefit in waiting, many expect to see a concerted effort by companies to renegotiate funding facilities early in 2009, once the year-end squeeze is over (see article).

In the face of more requests for waivers and refinancings, banks will react selectively. ... The lucky ones will still pay a hefty price for access to credit. Not only will the costs of borrowing zoom, but terms will become much tighter. ... For those firms that find doors starting to shut on them, the prospects are grim.

the outline of an obama "economic rescue" plan has cheered optimists, but i have to concur with turner. as ed harrison also noted last week, every government effort thusfar has met with futility as banks are simply not in a position to lend out reserves as they struggle with insolvency. the result has been spiking reserves on deposit at the fed and a collapsing money multiplier -- a liquidity trap. keynesian economic stimulus will certainly benefit some firms greatly and more broadly help maintain some level of aggregate wages and spending in the face of mounting bankruptcies and layoffs. but it will neither return the banks to health nor restore the credit markets to function, and this continuing dysfunction will ensure continued delevering, defaults and capital destruction. stimulus is a salve, not a cure. on the evidence gathered so far the cure, such as it may be, is quite probably simply further deleveraging and a weeding-out of the overindebted.

moreover, a return to a sustainable path will look on an international capital-flows level very much like the elimination of vendor finance. china, japan and petrodollar states have been complicit with the united states over the last twenty years in maintaining huge current account surpluses through the recycling of overvalued dollars. this long-noted misallocation must be corrected for international finance to rebalance in a sustainable condition. that will mean more foreign home-market demand and more savings within the united states, britain and other debtor nations -- either at current aggregate levels of production and consumption per capita or something rather less.

so far -- while petrostates have seen revenues crash and their participation in vendor finance decline dramatically -- the inertia of government on both sides is resisting this reversion. germany, japan and china have all taken steps to devalue their currency (in china's case) or cautiously approach stimulating domestic demand for fear of deficit spending. dani rodrik muses on the need of such spending to avoid a bout of protectionism. the economist also addressed these issues recently by noting that surplus nations have become overly dependent on exports.

Countries that have lived beyond their means may feel a justifiable remorse as their booms turn to bust. Surplus countries are simply stupefied by their plight. They should not be. A persistent current-account surplus is a symptom of unbalanced growth, just as a big deficit is. Countries that save too little to cover their capital spending are at the mercy of foreign investors; countries that save too much are at the mercy of foreign demand. China gets barracked for its current-account surplus, which was $372 billion last year, according to the IMF. Yet the combined surpluses of Germany and Japan amounted to a vast $463 billion.

If the world economy is to adjust to higher saving in shopaholic deficit countries, such as America, it will require surplus nations to stimulate their domestic spending. Germany, unlike Japan, can at least benefit from lower interest rates: on December 4th the European Central Bank cut them by 0.75 percentage points to 2.5%. It can also afford a much bigger fiscal stimulus than it has announced so far. Japan is far more constrained by its huge public-sector debt. But both countries can start by shaking off the mindset that demand has to come from somewhere else.

good as that sounds, change isn't forthcoming -- and as the economist notes, tendencies to save are reflexively strengthened by a downturn which has destroyed savings. given still cloudy but emergent reports of an ongoing deflationary collapse in china, the idea of increasing demand emerging from surplus nations seems very remote.

moreover, the governments of the united states and britain are firing every cannon and shell at their citizens in an effort to get them to borrow yet more and their banks in an effort to get them to lend yet more. but it won't happen -- mortgage securitization is dead, the banks are awash and downsizing, and social mood has moved from extravagance to thrift.

indeed one wonders if the likely outcome isn't simply a series of competitive devaluations ping-ponging between surplus and debtor economies -- one which germany would surely lose out on, failing a collapse of the euro. one should note that such manipulations of currency function as, among other things, little less than a series of import tariffs. indeed china's longstanding dollar-peg (followed by its dirty float) has fostered its reliance on exports while providing a shield against affordable imports, a mercantilist policy which has helped suppress consumer spending in china. those who worry about the return of smoot-hawley and regimes of protectionism would do well to monitor currency interventions. dani rodrik comments on competitive mercantilism.

so the adjustments necessary as a curative are being fought in each country even as palliatives to the status quo ante are being doled out by the barrel. if this generates cheer, it can only be as temporary as an aspirin.

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Linking to The Socialist Worker?? I'll let it slide, but only because you consistently direct me to great op-eds and blog posts I haven't seen.

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from perrone: hey, between the wall street journal and the socialist worker, who do you think's made the better calls? and who's world view is less like that turkey Taleb talked about, the one absolutely convinced of abundance and benevolence even as the farmer takes the axe from the shed and amples out to the coop . . .

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Point well taken. I think that has less to do with the people at the Socialist Worker being smart and more to do with them being able to think critically about the big picture without being bound by efficient market ideology. They do, however, adhere to a far more dangerous ideology.

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lol -- br, you don't know how i smiled and shook my head to link to that rag. if it weren't for the pedigree of graham turner in calling this mess, i certainly would not have. his book, "the credit crunch", is an detailed if unorthodox read. when the economist can praise it even though turner questions the validity of the accepted wisdom of free trade, you know it's worthwhile.

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and if this is not a time for unorthodox thinkng and a healthy skepticism of accepted wisdon, when would be? :)

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