My view of the crisis and trade imbalances
The New York Times has an article touching on the imbalances that we observed in the decade. It's a story told largely from the perspective of Ben Bernanke. I see some bloggers taking issues with the article and, although I don't have a strong view on the article itself, I think the criticism by some bloggers is simplistic and impractical. I will refer to two thoughts to illustrate some issues that is missed.
Housing is not the main problem!
The first blogger I want to refer to is Paul Krugman, who takes issue with the notion that the housing bubble was only known in hindsight. He correctly points out how he, as well as several others, were warning about the housing bubble for years. It would have been preferable if the housing bubble didn't inflate as much as it did, but we are not looking at the possibility of a depression because of that.
I think he, as well as many others--some prominent commentators, some not so prominent--are missing the core problem. My view is that the core problem is not housing! It is a big problem and possibly the largest real estate bubble in US history, but we have had many housing bubbles in the past with good subsequent recoveries.
It is also not, as some mistakenly believe, a subprime mortgage problem. The subprime market in the US is something like $700 billion and banks alone have wrote off more in losses than that.
The real problem, I would argue, is the mispricing of risk. The situation is bad because almost all risk was underpriced. I really wish it was limited to subprime real estate or real estate in general, but that's not the case at all. If it were, spending about $500 billion to, maybe, $2 trillion (depending on your recovery assumptions, inflation assumptions, and so forth) would easily solve the problem. Yet, the US government alone has spent almost a trillion (depending on how you count the capital injections) and the problem is as bad as it was 6 months ago or even 1 year ago.
Risk was completely mispriced. Something that is very detached from real estate, say investment grade corporate bonds, were underpriced as well. Corporate bonds of non-housing-related companies would not sell off to the degree they have if this was a housing problem.
If you are an investor, I think it is extremely important to realize that the core problem is the mispricing of risk. The underpricing of risk also, not surprisingly, led to increase in debt usage. After all, if cost of debt was low, market participants are inclined to use greater amount of debt.
What has happened because of the underpricing of risk is that the market has lost trust in financial institutions, asset prices, economic numbers, and even some governments. What this means, in my view, is that, if you are taking a bullish view and are macro-inclined (if you are bottom up, you may not care about macro,) then you need to realize that a housing recovery will not necessarily result in the good old days. This is one reason I am maintaining my bearish view of the economy; but unlike some I am not superbearish and am not expecting a depression. I really don't see cyclicals, such as commodity businesses, retailers, and auto manufacturers recovering quickly. Some of the bloggers I read, along with reader or forum posters, are gearing up to take strong pro-growth bets (such as betting on oil) but I'm concerned about the outcome of that.
So, I would say that even if the housing bubble wasn't as large, we would be facing similar issues.
Trade War
I would also like to refer you to Yves Smith of Naked Capitalism who seems to favour a trade war with China. As she correctly points out, the imbalances were driven by various issues such as the undervalued renminbi peg to the US$. I would argue that the trade war that she is calling for would end up in a total disaster. We would probably end up worse off than now. On top of a trade war being very risky, it is totally impractical even 5 or 6 years ago.
It is also very easy for one to say what should happen but that's not how the free market works. It's easy for everyone to say that Americans (and Canadians too) have been living outside their means and consuming too much. But no one can imlement a plan to rectify that. The consumers are just actors in a free market and they will act in their interest. If someone is offered cheap credit, they will take it. If investors are willing to finance the lifestyle of someone, they would take it. The market forces are far more powerful than any government!
People, including prominent economists such as Stephen Roach of Morgan Stanley, had been warning about the trade imbalance for years but it is impossible for any invidual or government agency to rectify it. Only market forces can fix these problems and we are seeing the forces at work now.
Housing is not the main problem!
The first blogger I want to refer to is Paul Krugman, who takes issue with the notion that the housing bubble was only known in hindsight. He correctly points out how he, as well as several others, were warning about the housing bubble for years. It would have been preferable if the housing bubble didn't inflate as much as it did, but we are not looking at the possibility of a depression because of that.
I think he, as well as many others--some prominent commentators, some not so prominent--are missing the core problem. My view is that the core problem is not housing! It is a big problem and possibly the largest real estate bubble in US history, but we have had many housing bubbles in the past with good subsequent recoveries.
It is also not, as some mistakenly believe, a subprime mortgage problem. The subprime market in the US is something like $700 billion and banks alone have wrote off more in losses than that.
The real problem, I would argue, is the mispricing of risk. The situation is bad because almost all risk was underpriced. I really wish it was limited to subprime real estate or real estate in general, but that's not the case at all. If it were, spending about $500 billion to, maybe, $2 trillion (depending on your recovery assumptions, inflation assumptions, and so forth) would easily solve the problem. Yet, the US government alone has spent almost a trillion (depending on how you count the capital injections) and the problem is as bad as it was 6 months ago or even 1 year ago.
Risk was completely mispriced. Something that is very detached from real estate, say investment grade corporate bonds, were underpriced as well. Corporate bonds of non-housing-related companies would not sell off to the degree they have if this was a housing problem.
If you are an investor, I think it is extremely important to realize that the core problem is the mispricing of risk. The underpricing of risk also, not surprisingly, led to increase in debt usage. After all, if cost of debt was low, market participants are inclined to use greater amount of debt.
What has happened because of the underpricing of risk is that the market has lost trust in financial institutions, asset prices, economic numbers, and even some governments. What this means, in my view, is that, if you are taking a bullish view and are macro-inclined (if you are bottom up, you may not care about macro,) then you need to realize that a housing recovery will not necessarily result in the good old days. This is one reason I am maintaining my bearish view of the economy; but unlike some I am not superbearish and am not expecting a depression. I really don't see cyclicals, such as commodity businesses, retailers, and auto manufacturers recovering quickly. Some of the bloggers I read, along with reader or forum posters, are gearing up to take strong pro-growth bets (such as betting on oil) but I'm concerned about the outcome of that.
So, I would say that even if the housing bubble wasn't as large, we would be facing similar issues.
Trade War
I would also like to refer you to Yves Smith of Naked Capitalism who seems to favour a trade war with China. As she correctly points out, the imbalances were driven by various issues such as the undervalued renminbi peg to the US$. I would argue that the trade war that she is calling for would end up in a total disaster. We would probably end up worse off than now. On top of a trade war being very risky, it is totally impractical even 5 or 6 years ago.
It is also very easy for one to say what should happen but that's not how the free market works. It's easy for everyone to say that Americans (and Canadians too) have been living outside their means and consuming too much. But no one can imlement a plan to rectify that. The consumers are just actors in a free market and they will act in their interest. If someone is offered cheap credit, they will take it. If investors are willing to finance the lifestyle of someone, they would take it. The market forces are far more powerful than any government!
People, including prominent economists such as Stephen Roach of Morgan Stanley, had been warning about the trade imbalance for years but it is impossible for any invidual or government agency to rectify it. Only market forces can fix these problems and we are seeing the forces at work now.
Good points.
ReplyDeleteBut I have to take issue with the notion that markets are stronger then governments. It isn't so. If a government wants to crush free markets like a bug it can do so almost instantly.
The only problem is that such an action has all sorts of, usually nasty, side-effects so most of the time cooler heads in governments refrain from crushing markets.
But seriously, when a government was determined (Russia immediately after the revolution, 1930's Soviet Union, any communist state thereafter, Zimbabwe, Western Europe in the seventies)when did it ever fail to crush the free market?