Friday, 2 January 2009

The decline in US asset prices and the perspectives for the global economy

The fundamental assessment presented on this blog, for underlying macro and structural economic reasons, has been that the financial events of 2008 portend a deep world recession but not an economic depression of the type witnessed in the 1930s. This deep recession will be accompanied by a major strengthening of their positions in the world economy by China and India, and to a lesser extent Russia. [1]

To gauge the degree of seriousness of the economic crisis it is evidently merely necessary to consider the depth of the fall in financial markets. The decline in asset prices in 2008, as discussed in detail below, was fully comparable to 1929 - and greatly exceeds any fall seen in the period since. However whatever the similarities in financial markets the world macro-economic situation differs significantly to 1929.

In 1929 the US was not only the world's largest but also the world's most dynamic economy with the highest rates of savings and investment. When the US financial system entered deep crisis in 1929, therefore, there was no external economic force that could pick up either it or the world economy – no economic backstop. The financial implosion in the US in 1929, therefore, necessarily dragged the world economy down into the abyss of prolonged depression.

In 2008 the configuration of world economic forces differs significantly. China and India are today the world's most dynamic large economies. with the world's highest savings and investment rates and the most rapid economic growth. Furthermore China has sufficient economic weight, in terms of world savings, not to prevent international recession but to be a significant counterbalance to the situation in the US.

China's savings and investment rates are not only far higher than the US as a proportion of GDP but are also now approximately equal to those of the US in absolute terms. India's internal savings and investment rates, now at over 30 per cent of GDP, are also far higher than those of the US - enabling it to maintain significant economic growth in what is, in real terms, now the world's fourth largest economy.

For the relative trends in US, Chinese and Indian investment rates see Figure 1.

Figure 1

The world has already been saved once from the consequences of US financial crisis in the last economic period. Following the 1987 US stock market crash the export of financial resources from Japan, carried out via an ultra-expansionary monetary policy, played a crucial role in stabilising both US and world financial markets. Whether Japan was wise to purse these policies in the particular form it did, in light of the consequent Japanese 'bubble economy' and financial crash which commenced in 1990, is another issue, but it showed that there was now an 'economic backstop' for the US in the world economy in a way that one had not existed in 1929.

This economic strength of China, and to a lesser extent India, therefore significantly alters the situation of the world economy compared to 1929 - despite any apparent parallels on financial markets. Provided there are not disastrous economic policy miscalculations by the US, which of course are possible, international macro-economic fundamentals mean there need be no 1930s style depression. However there will be, instead, a deep recession of the global economy out of which China and India will emerge significantly strengthened in their relative weight in the world economy. This is therefore the conclusion which flows from consideration of international economic fundamentals.

Nevertheless, first it is possible that the US government will make disastrous economic miscalculations. The reason for this is that a rational economic course by the US administration requires it accepting its reduced role in the world economy – one in which the US is the world's largest economy but no longer an unchallengeable economic superpower. It is possible therefore that there may be future, George W Bush type, US administration attempts to escape a rational economic outcome which may fundamentally destabilise the international economic situation - posing the risk of turning a recession into an economic depression.

Second, it is constantly necessary to check economic fundamentals against facts - the weight of individual elements may be misjudged or factors that were not taken into account may be operating. Macro-economic data that would verify, or disprove, an assessment of 'deep recession but not economic depression' is not yet available for the period following the decisive financial events of September 2008. However trends for financial markets are available. The end of 2008, therefore, represents a convenient opportunity to sum up the qualitative situation revealed by financial markets and to compare it to the assessment of economic fundamentals.

Considering first the area in which the financial crisis originally manifested itself, that is in US house prices and sub-prime mortgages, the decline of US house prices is now more rapid than at the time of the Great Depression following 1929. US house prices in October 2008 were 18 per cent lower than a year previously - the fall being 2.2 per cent in October alone. The rate of decline is still accelerating. The annual fall in individual US cities such as Phoenix, Las Vegas and San Francisco was greater than 30 per cent. The decline in the price of US housing assets at the end of 2008 totaled around $7.1 trillion.

Turning to shares, the fall in the Dow Jones Industrial Average in 2008 was 33.8 per cent – the worst annual fall since 1931 in which year the decline was 52.7 per cent. Share prices in the US financial sector declined by 57 per cent in 2008.

The most relevant, because most long term and fundamental, comparison continues to be that of the current decline in US share prices with the fall in US shares after 1929. Figure 2 confirms that the fall in US share prices, since their peak in October 2007, continues to far exceed the other major declines of the 20th century – either that following the beginning of the international recession in 1973 or the collapse of the dot com bubble in 2000. Only the fall in US share prices following 1929 is comparable to, or exceeds, those which have occurred over the last year. There is, therefore, no element of exaggeration to say this is the worst fall in financial assets since 1929 nor are comparisons to that date, in the financial field, unjustifiable exaggerated.

Figure 2

Considering the comparison with 1929, 31 December 2008 was 313 trading days after the peak of share prices during the current cycle on 9 October 2007. The Dow was 38.0 per cent below that peak. On the equivalent trading day following 1929 the Dow was 52.0 per cent below its peak in that cycle.

The wider based S&P 500 fell by 41 per cent in 2008, the worst decline since a parallel measure would have dropped by 47.1 per cent in 1931.

The slightly lesser decline of the Dow and S & P 500 in the current cycle, compared to 1929, is however primarily due to the relative stabilisation of US share prices since large scale state financial intervention commenced from late September 2008.

This relative stabilisation of US share prices ran in parallel with the improved conditions in interbank lending similarly created by huge state intervention – see Figure 3.

US Federal Reserve loans rose from $900 billion in September 2008 to $2.2 trillion by December 2008. Already projected Federal Reserve exposures range up to $5 trillion.

Figure 3

However, as may be seen from Figure 2, the most important difference between the present decline in share prices and that after 1929 is the duration of the fall. Following 1929 US share prices continued to fall for three years, with the worst decline being in the second full year of the drop in 1931. So far the decline in US share prices in this cycle has progressed for only just over a year before being halted, at least temporarily, by massive transfers of resources by the state.

Taking non-US stock exchanges in 2008, the UK FTSE 100 declined by 30.9 per cent and the FTSE All Share index fell 32.8 per cent - its worst annual fall since losing 55.3 per cent in 1974. The Germany Xetra Dax fell 40.3 per cent, the Paris CAC 40 fell by 42.1 per cent and the FTSE Eurofirst 300 suffered an annual decline of 44.7 per cent.

The Nikkei 225 index in Tokyo ended by recording a 42.1 per cent fall in 2008, worse than its previous biggest annual loss of 38.7 per cent in 1990. Korea's Kospi index ended the year with a decline of 40.7 per cent.

The conclusion from these trends so far, therefore, is that massive state intervention succeeded in both reducing interbank interest rates and stabilising share prices during the final two months of 2008. But what is its capacity to fundamentally reverse the decline in asset prices that created the crisis in the first place – for, as noted elsewhere, it is the fall in asset prices which is creating the pressures to a liquidity crisis, and not a liquidity crisis that caused the fundamental decline in asset prices?

It is here that the other valid scale of comparison is that with Japan following the bursting of its national asset price bubble in 1990. As may be seen from Figure 4, the decline of the Japanese Nikkei share index after 1990 remains, in terms of duration, considerable worse than that of US shares following 1929. Japanese property prices, equally, remain deeply depressed 18 years after the bursting of the asset bubble.

Such experience indicates that there must, therefore, be no automatic presumption that there will be any V shaped recovery of share prices or asset values – i.e. that the fall in asset prices will be merely short lived followed by recovery. Contemporary, as well as historical, experience indicates that the depression of asset prices below their levels of 2007 may be of long duration.

Figure 4

Such economic processes create a new configuration between the state and the financial system.

Given the magnitude of the financial shifts it is evident that the international financial system is in intensive care with its artificial respiration system being currently powered by state finance. Nor, given the scale of the resources involved, is this situation likely to be reversed in the short term – any perspective that the state will be able to sell back, without huge losses for the taxpayer, the assets it has acquired in any short time frame are illusory. The economic rise of China and India is, therefore, being accompanied by a massive increase in the role of the state in the US and Western Europe.

The scale and pattern of the decline in asset prices means that a world economic depression can, as noted at the beginning of this article, be avoided. But a fundamental change in the configuration of the world economy cannot.


[1] In Latin America the outcome is not yet determined and will depend on the policies adopted.

1 comment:

Mr Banks said...

A question on Russia

Once again, an excellent piece. One query, though, which I hope isn't a distraction.
Why will Russia outperform the Western economies over the next period? It has been transformed into a commodity producer wholly dependent on world prices, and, crucially it has a low investment rate (probably declining). There was a huge flight of capital following the Yeltsin coup and the current Putin regime is also busy squandering the huge arsenal of FX reserves by baling out the oligarchs.
Surely the BRIC is a misnomer (probably always was) and the policy-driven effect will be that China and India will count for a far greater weight in the world economy than Russia or Brazil?