By Michael Spence
The crisis we are now in globally had its origins in an asset bubble fuelled by the interaction of excessive leverage and a widespread underestimation of the endogenously rising systemic risk – roughly the degree to which individual risks were becoming highly correlated via balance sheet linkages. The potential seriousness went unnoticed or not fully understood (by market participants, regulators and commentators) for several years.
That is no longer the case. It has been known for some time that leverage had to be reduced, asset values reset down and consumption levels reduced for a period of time, at least in the developed economies. I believe that we underestimated the extent of the potential damage to the real economy that would result from the feedback loops connecting balance sheets and the decisions that underlie the income statements (consumption, employment and investment) throughout the economy, in the financial, business and household sectors. These interactions are at the centre of the current downward spiral.
But it is now worse that this dynamic might have implied. The declines in asset prices and real economic activity are in danger of going well beyond any reasonable assessment of what would have been required to restore the advanced economies to a more balanced configuration. More seriously, it is not clear where the natural stopping point is – and that is creating fear, feeding back into investment and operating behaviour.
Value investors are largely sidelined. That is understandable in part, because jumping in too early, particularly in the financial sector, produced losses; and now the asset deflation has spread to all sectors, reflecting the corresponding damage on the economy side, why take the risk? But much more importantly, in this high speed downward spiral, with the balance sheets adversely impacting the income statements and vice versa, it isn’t clear what the intrinsic values are. They are endogenous to the system as are investor expectations. Increasingly both will be determined by what governments do.
One would not want to use the term equilibrium in this kind of volatile situation, but whatever the correct term, the dynamics appear to be such that there are multiple places to bottom out, more or less rank orderable by either the extent of asset deflation or the reduction in economic activity.
The channels underpinning the dynamics are clearer. One is an inability to intermediate credit which threatens business viability and aspects of household consumption. This has largely been dealt with on an emergency basis, as has the deposit risk associated with bank failures. The second one is still operating and has a first order impact. It runs from reduced asset values combined with extreme uncertainty about the extent of future declines, to the real economy via consumption and with a short lag on employment, investment and expected profits.
There are few natural circuit breakers that interrupt these channels. The capital adequacy vacuum in the developed countries spread rapidly to the developing world in the form of emergency capital outflows, creating negative exchange rate dynamics and credit issues that had little to do with conditions in these economies. The potential damage has been partially reduced by a reversal of these capital outflows by the IMF, by the use of reserves and by dollar swap facilities from the US Federal Reserve.
The global system has become highly interconnected and non-compartmentalised, and hence quite fragile. It makes the dynamics more vicious as few parts of the global economy seem to be sheltered.
Preventing a serious overshoot in the balance sheet–income statement downward plunge is a co-ordination problem. Intrinsic value and hence investor behaviour is determined in part by consumer and business behaviour and vice versa. The co-ordination problem in breaking the cycle and the need for simultaneous action is in part understood: the G20 summit was right to focus on protectionism and coordinated fiscal stimulus to avoid beggar-thy-neighbour and free-rider problems.
Government is the only entity that has the capacity to intervene in a co-ordinated way to shift the dynamics by weakening the reinforcing two-way linkages, with the goal being to cause a deceleration in the rate of decline and ultimately to limit the negative overshoot in assets and economic activity. Not only are governments (including central banks) the only natural candidates for this function, they have also become major players in the system. It is crucial that their future behaviour becomes predictable. Because one is dealing with expectations on the asset side especially, communication and credibility are important as well as action.
To address the interacting deflationary effects, we need not just a significant stimulus package (global if possible, credible, and announced in advance) but a larger and much more systematic programme of buying assets. Housing and mortgages would be a good place to start. Without such a systematic programme, asset deflation will very likely for an extended but unknown period of time undo some of the beneficial effects of a stimulus package and vice versa. Further, asset values are driven (except for some of the technical factors operating now) by expectations. These adjust very quickly and hence can cause damage quickly.
Addressing the asset deflation side of the challenge is crucial. It is also very hard. In these circumstances, intrinsic values are endogenous variables. The point of the intervention is not so much to guess at them accurately but rather to affect them positively. Trying to change an “equilibrium” outcome is much more complex than assessing asset values in a fairly stable environment. There are not many market price signals to use as reference points, leaving the public sector as investor open to a wide variety of critiques. And perhaps fortunately, they and we don’t get much chance to practise beforehand