The capitulation of Wall Street this morning, with the S&P500 down 6.1 per cent, is a dire warning that the near collapse of the financial system after Lehman Brothers bust in September is already a distant memory.
Yes, the world’s governments did well to save the banking system from catastrophe, but it was already too late to save the economy.
It looks like the Warren Buffett-inspired rally on stockmarkets has already been snuffed out. Investors are discovering that oversold does not necessarily mean undervalued.
The drama on the sharemarket, and what it portends for the economy, has enormous implications for government budgets as well as the corporate earnings, the health of which the stockmarket is trying to get a fix on.
So far the world’s governments, including Australia, have been acting like pawnbrokers and/or loan sharks, but that will soon change and more traditional Keynesian economics will replace usury.
That’s not to suggest the bailouts announced so far were not necessary or good: a financial catastrophe was avoided, as Reserve Bank governor Glenn Stevens pointed out this week, and we will never really know how close we came.
But this morning’s big fall in the Dow Jones reminds us that the global economy is still in dire trouble and that, as Martin Wolf put it in his Financial Times column yesterday, the world is waking from its “wish-dream” of decoupling.
But it is wrong to portray most of the actions taken by governments so far as “bailouts”, suggesting that taxpayers are making up for the consequences of investment banking excess.
In fact, virtually all of the actions taken during the crisis of the past five weeks have involved governments either mopping up distressed loan assets at cheap prices like pawnbrokers, buying bank equity at huge discounts like vulture funds, or supplying guarantees for bank deposits at loan shark rates.
The Australian government, for example, is offering to buy $4 billion worth of residential mortgage backed securities through the Australian Office of Financial Management. There’s not much doubt that the purchases, if there are any, will take place at or near the bottom of the market and that the government will do pretty well out of the investments. After all, no one else is in any position to buy them.
The same goes for similar recapitalisation funds created in the US, UK, Canada and most European countries. Japan is operating on a case-by-case basis.
The bank deposit guarantees will all cost money if they are used.
The letter from Glenn Stevens to Ken Henry providing advice on the structure of the government’s deposit guarantee proposal, and published in The Australian this morning, suggests the following pricing for five year guarantees: AA 70bps, A 100bps, BBB 150bps.
He goes on:
This is crude, arbitrary, but simple. It can be defended on the grounds it is cheaper than the UK is offering and generally a bit higher than the flat 75bps the US is offering. It is higher than normal pricing would be. And its price for short-term insurance is quite high. An alternative which has certain attractions would be to adopt the UK model of CDS spread plus 50bps. The figures I have seen say that would end up over 200bps in general for all our banks. (Not all banks have CDS contracts written on them so that is an issue with that approach).
The point is that the guarantee will not cost the government money and will not reduce the budget deficit.
The recession will do that. Indeed there must be every chance that next year’s budget for 2009-10 will be the first deficit since 2001-02, and a huge turnaround from the $19.7 billion actual surplus from 2007-08.
Budget surpluses have become the bedrock of fiscal responsibility in Australian politics, to be maintained at all costs. This attitude will have to change next year and the Australian polity will have to embrace deficits.
Keynes will be back in vogue everywhere and budgets will be in deficit. It will not be a question of whether a budget is in surplus or deficit, but which governments can ride out the storm and issue enough debt to stay afloat — without having to tax citizens who can’t pay, or retrench pubic servants who can’t get a job.
For example the US, UK, France, Italy, Portugal, Greece, Japan, Ireland, Austria, Germany, Belgium and Canada all go into this recession with general government financial balances in deficit, according to RBC Capital markets. Australia has a positive balance of 1.5 per cent of GDP.
The world is likely to be flooded with government bonds, on top of the money printed by central banks to finance their liquidity injections. Inflation is probably inevitable at some point, as Marc Faber asserts, but in the meantime the bogey is deflation.