Brace for Act II when the crisis goes global

By: Wolfgang Münchau

There has been some good news in the past week and a lot more bad news. The good news consisted of tentative signs that the credit markets were stabilising. Conditions in the asset-backed commercial paper market also appeared to improve. The bad news was the shocking bail-out of Northern Rock, a UK mortgage bank.

I would nevertheless suspect that within a few months, the banking sector will have absorbed most of the horrible real estate investments and the financial markets will be celebrating an end to the crisis.

Unfortunately, I fear this is only going to be the end of Act I. Act II plays out in the real world. Act II begins with a sharp slowdown in US economic growth. The two obvious questions that arise from this scenario are: how bad will the US downturn be and how contagious will it be?

It looks as though it will be bad. Some optimists had hoped that the rest of the world could easily withstand a US recession and invented the infamous de-coupling theory. What they did not count on was the rapid decline of the US currency as expectations of a US recession were rising. A weak dollar is going to be the main global transmission mechanism.

Against the euro, the dollar last week recorded its lowest value since the start of European economic and monetary union in 1999. Forecasting exchange rates is an inherently dangerous game. Some market observers are now preparing for the bilateral exchange rate to move into the $1.40-$1.45 range. While the euro area has been able to withstand the appreciation of the euro without damage – and with surprisingly little noise from Paris – I would expect both of these benign factors to disappear suddenly once the euro breaks through $1.40. There is nothing magic about this particular number, but it will serve as an excuse for recriminations.

Short spikes in an exchange rate do not have much economic effect, but if the exchange rate were to remain in the $1.40-$1.45 trading range for a long period, it would no doubt affect eurozone exports and growth. Add to this the more direct effects of the credit crisis plus the global cyclical slowdown that has already started and you have the ingredients for a sharp downturn. If the US economy tanks, the rest of the world will follow with some delay. Act II of the crisis is therefore the transmission from the US to the global economy.

One could also look at this in another way. There are two independent crises playing out in successive fashion. One is the crisis of the securitised financial markets. The other is the crisis of global imbalances, a micro and a macro event respectively.

The debate about global imbalances, which raged in the years 2004 and 2005, may have died down, but the problems have not been resolved. “If something cannot go on forever, it will stop,” Herb Stein, economic adviser to former US President Richard Nixon, once famously remarked. This is what Act II is all about.

It is worth revisiting an important paper on this subject, written in 2004 by the economists Maurice Obstfeld and Kenneth Rogoff*, in which they construct a model that shows in detail how global imbalances are likely to unwind. They argue that the process would begin with a sudden shock – they presciently envisaged a US recession brought about by a fall in house prices. As part of this process the value of the dollar would fall significantly.

The mechanism described in this paper bears an uncanny resemblance to the events we have already witnessed in Act I of our drama. The good news is that the certain fall in US interest rates, combined with a fall in the dollar, will eventually do the trick. The bad news is that this might take a lot longer than in 2001. The Fed will cut interest rates, but not by nearly as much as it did then. In Europe, the European Central Bank had even planned to raise interest rates, and some central bankers are still pretending as though this was still the case.

I would expect cries of “too little, too late” to dominate the monetary policy debate during Act II, as contagion spreads from the US to the rest of the world.

By the end of Act II, there is a reasonable chance that global imbalances will have unwound. US imports will have fallen. Exports will rise, as will the savings rate.

Will there be an Act III? Quite possibly. Moody’s, the rating agency, has predicted that a US recession could see a rise in corporate default rates from 1.4 per cent of rated companies last year to about 12 per cent – a level last seen during the early 1990s and after the dotcom crash. When that happens, it will be interesting to see how the credit markets will cope. Many investors have over-optimistically agreed to sell insurance against corporate defaults through credit default swaps, a market that has grown exponentially in the last few years. This raises a number of questions: how many of these guarantees will have to be invoked, how much of this will be actually paid, and what happens if investors default en masse?

The subprime glitch may soon be over. But the credit and global adjustment crises have only just begun.

*The Unsustainable US Current Account Position Revisited, NBER Working Paper No. 10869, 2004

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Copyright The Financial Times Limited 2007

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