Monday, April 20, 2009

Where Are We In The Financial Crisis?

The answer is that we are in transition. The crisis has turned a corner, but obstacles lie ahead. Government interventions in the financial sector and the real economy are starting to gain traction.

This is a major change. Two months ago, the major economies were in free fall. A full global downward spiral in which the damaged balance sheets in the household sector led to reduced consumption and then reduced investment and employment. Similar damage in the financial sector led to very tight credit, reduced consumption and investment.

Those relative destructive interactions and dynamics have started to abate.

The downward resetting of asset values was inevitable as was the reduced consumption and increased savings that they caused. The uncertainty leads to fear and cautious behaviour on the part of consumers, businesses and investors. Defer the purchase of a car until you figure out what your house is worth or whether you will lose your job. Wait until the asset markets clearly turn before jumping in to buy bargains.

The effect of these sensible choices is a collectively destructive outcome in which asset values and activity in the real economy decline beyond the point required to get rid of the imbalances that initiated the crisis.

Cue the government. In the past two months, governments have taken actions that over time will short-circuit some of these negative feedback loops. There are stimulus packages of varying sizes. Governments are consuming and investing for us on an interim basis until stability and confidence are restored.

These programs are only starting to be implemented and we have not felt the full effect. The anticipation of their impact is having a more immediate effect on business confidence and asset prices. The financial side of the equation is equally important and complementary. The impact of the stimulus comes in rounds.

The government hires me to repair a bridge and I spend my income generating / expanding business and employment somewhere in the economy. These subsequent round effects are called multipliers. Their size depends on the financial system. Specifically, if consumers and businesses can’t get credit or if asset prices are still plunging, consumers and businesses remain cautious and the multipliers (the second, third and fourth round effects) muted.

Restoring credit at reasonable prices and building confidence so that value investors return to the asset markets will therefore amplify the impact of the fiscal stimulus and vice versa.

So where are we? Probably at the start of the process of turning the corner.
That can happen quite quickly in the capital markets and much less so in the real economy. In equity markets, rallies similar to the current one are likely, based on what might be called the reduction of extreme pessimism.

But the real economy continues to lose jobs at a rate in the US of about 650,000 a month.

That will take time to decelerate. How fast will determine how much further damage there is to credit quality and hence the ultimate issue of solvency in financial institutions.

Edited from an article posted by Michael Spence, a former dean of Stanford University’s graduate business school and a 2001 Nobel laureate in economics.

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