November 17, 2009 3:36 pm

Doomed to repeat history?

The warning that “those who cannot learn from history are doomed to repeat it” is usually a caution against complacency. However, the past can teach us another lesson too – that not all crises need end badly.

We cannot judge how sustainable recovery will be or act to reduce the risk of another financial crisis if we do not understand the real cause of the downturn. A critical distinction must be made. Was the problem excessive consumer debt or was it primarily an issue of leverage within the financial system? Monetary policy will fail if consumers won’t borrow at any price.

The financial system, on the other hand, can sometimes be recapitalised and reformed with little or no lasting damage to the real economy.

Those who put greater weight on the consumer debt explanation argue that the Anglo-Saxon property bubble has burst once and for all with much of the bad debt, in effect, transferred to governments when they underwrote bank assets and eased fiscal policy. Comparisons are made with Japan’s two-decade property bust, the apparently inevitable conclusion being that fiscal retrenchment and weak credit demand will be a long-lasting drag on growth. By implication, the rise in stock prices since March can be dismissed as a Japan-style bear market rally.

A high US consumer debt burden was certainly a contributory factor but I would argue that it was the leverage that had built up within the financial system that turned slowdown into slump. When price declines in the US housing market led to losses on asset-backed securities, mark to market accounting set in motion a vicious debt-deflation spiral that Irving Fisher would have recognised. The more prices fell, the more over-geared institutions were forced to sell. Meanwhile, the downward impetus in home prices gained force from misguided non-recourse lending rules that allowed US homeowners to walk away from their mortgage obligations.

Over the ensuing eighteen months everything from inter-bank lending to trade finance was called into question as financial institutions hoarded cash. The cycle of distrust was eventually broken by government intervention. Central banks became a kind of counterparty clearing house in the money markets. Fiscal authorities stepped in to guarantee retail deposits and shore up bank balance sheets.

It certainly did not feel like a consumer-led recession. I would say the average consumer was only dimly aware of the crisis until Lehman was allowed to fail and mass layoffs hit home. US consumers are reacting, as might be expected after such a shock, by paying down debt. They are clearing the slate. There’s no reason to believe that they will not take on debt once more when confidence returns. Witness the recovery of the UK housing market.

According to a recent IMF study of 88 post-war banking crises, the “average” experience results in a permanent loss of output amounting to 10 per cent of GDP. However, there is a very wide dispersion of outcomes and one-in-three have no long-lasting effect. The better third are associated with aggressive fiscal and monetary stimulus. You’d have to say we tick those boxes.

The early recognition of losses, forced recapitalisation of the banks and a deliberate policy of quantitative easing to inflate collateral values also raise hopes that the banking system can revive before large swathes of productive capacity are irretrievably lost.

Businesses that reacted to the credit freeze by cutting production, deferring capital spending and slashing employment are starting to reverse their decisions. Consumer spending is strengthening as savings rates stabilise and income picks up. A rebound in tax revenues should help to put government debt on a firmer footing without the need for too much fiscal retrenchment. Meanwhile, ample spare capacity should keep inflation low and monetary policy loose. This is a positive backdrop for risky assets and it seems likely we have embarked on a multi-year bull market in stocks.

It does not automatically follow that another financial crisis is in the making. A recovery in asset prices is part of the solution to debt-deflation and a sharp rise is to be expected after a sharp decline. It would be a mistake to ask central banks to decide the ”correct” market level. Any investor will tell you it is not easy to recognise a bubble. It is, however, easy to recognise leverage and that is something central banks are well-placed to do.

We are not doomed to repeat history. It is hard to alter human nature but regulatory failure can be addressed. We need effective oversight of leverage in the financial system. That’s all.

Trevor Greetham is Director of Asset Allocation at Fidelity International

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