September 15, 2008capital marketsEconomyfinancial marketsfiscal policyglobal economyguest postIndiamacroeconomicsmonetary policyUnited States

By Invitation: Buy lots of mattresses

Wall Street woes

This is an archived blog post from The Acorn.

By V Anantha Nageswaran

In the last few months, financial markets had got used to the idea of the authorities conjuring up some solutions to problems in the US financial industry over the weekend and announcing it on Monday morning (Asian time) in time for the Asian stocks to open higher. This routine worked initially but when problems did not go away, the impact became rather muted.

Unfortunately for Lehman Brothers such a weekend solution did not arrive. Late on Sunday evening in the US it announced that it was going to declare bankruptcy. Wanting to avoid that fate, Merrill Lynch sold itself to Bank of America. Some called it tectonic shifts on Wall Street. Alan Greenspan, former chairman of the Federal Reserve said that America was facing once-in-a-century financial crisis. He should know better because he played no small role in creating it.

For those who sleepwalked through the last one year the flashback is this: American financial intermediaries lent too much to too many to buy too many homes that they did not need; they lent money to builders to build too many of them and then proceeded to package those loans into further products and sold it to many in Europe and other parts of the world. European banks did the same as well. When those who borrowed found it difficult to pay mortgage instalments, the juggernaut stopped rolling and started going into reverse. Mayhem followed.

Home prices fell and mortgage arrears piled up; loans did not get collected; homes had to be foreclosed; inventory of unsold homes rose and financial products (‘innovations’) made out of such loans unraveled. Two of the high profile casualties of this mayhem have been today’s Lehman Brothers and Merrill Lynch.

In the meantime, American International Group (AIG), an insurance company, is perilously close to extinction as is Washington Mutual and scores of others. It is silly to think one could explain how American financial pride could have been so irretrievably dented. But I shall try.

Years of accumulated bad incentive and reward practices, false and pretentious homage to risk, regulators’ wink-and-nod at such practices, low interest rates and academics’ cheerleading right and high sounding words like transparency and innovation leading to hubris on Wall Street could be counted as core causative factors. Finally, the point tipped.

Given America’s pre-eminent role in global financial and economic affairs, it has and will have global repercussions. Severe global recession bordering on depression or global depression itself cannot be dismissed simply because we find the possibility loathsome and scary. Most optimistic forecasts on economic and financial variables arise out of the fear of facing the unpleasant. That is another problem of the industry.

In spite of such high drama, financial industry problems in America are a sideshow. The real crisis is the potential collapse in global aggregate demand if American consumers decided wisely to rebuild their battered balancesheets. The average American household hardly saves any out of disposable income. Asset markets did their job. Now that asset markets have pulled the shutters down, Americans have to search for their kitty box, locate it and start using it.

The world is going to be unhappy. They have gotten used to selling goods to Americans and to lend money to them so that they would buy those goods. Now, they face the prospect of their market disappearing and being saddled with hopelessly worthless IOUs denominated in American dollars whose value has now become indeterminate at best and negligible, at worst.

In the meantime, with few exceptions (India and Brazil), they had forgotten how it is to grow their economies of their own accord. India got most things right on financial and capital markets and interest rates but some one forgot to teach its government the basics of bookkeeping and budgeting. This is probably the first time that an economist and a lawyer would bequeath a fiscal mess to the next government.

What and where is the end and how? I wish I can see that and say that. No, I do not know. Being prepared for the worst—two years (if we are lucky) of low or no growth in the world and another 20% to 30% decline in asset prices—is a good way to start.

Buy lot of mattresses to store savings under. It is better if the cash is in multiple currencies. Precious metals would help too because they are neutral currencies.

This is going to cost the United States dear in more ways than one. I would leave it to the owner of this blog and people like him to figure out those costs.

Will America emerge out of this stronger? Again, I find this question too speculative for me to answer. Believers of American dynamism and demographics answer in the affirmative and sceptics point to historical demise of empires caused by hubris and overreach. The United States qualifies on both counts now. But, one small problem: there is no alternative to the United States now. Al Qaeda is not the alternative. Vacuums are dangerous.

If you are a believer, it is a good time to start praying. Non-believers can get ready for combat.

These are Dr Anantha Nageswaran’s personal views.

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