Market Risk: Why Upside Moves Will Not Be Easy

07/21/10 — When economic bailouts were being handed out like candy to kids at Christmas, I had to speak against them, but mostly in the context of not seeing even a trace of planning for exit strategies. What kept me on edge was the fact that I could not see the reset of economic and financial activity before the recovery could grow roots for real. Knowing the reset would be unpleasant, I also feared the longer it took, the worse it would get.

Initially, what unsettled me was that the resetting would not happen anytime soon. Now I fear that, happening all at once and soon, the reset could actually create more harm than the crisis that has necessitated it. This is simply because all the fiscal and monetary cards have been played out to deal with all the craziness that followed the freaky fall of Lehman Brothers almost two years ago and none are left.

I mean it: I think there is virtually nothing left — either politically or economically — that could generate the badly needed multipliers and economic drivers. The bailouts have been handed out to the point of asphyxiating government finances. The costs of borrowing have nearly evaporated. Fiscal deficits have hit the stratosphere. All of which means that there is no more flexibility and, when there is no flexibility, there are no options.

This is how cycles work. Typically, recessions exist to purge excesses created by previous recoveries. However, the Great Recession did not purge all the excesses, if it had purged any at all. Consumers and governments are still struggling under mountains of debt. House prices in many regions are still higher than what real estate market fundamentals command. People are still driving ostentatious cars. The way it looks to me is that all that money really
did little, if anything, to reset the underlying infrastructure of the global economy.

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This is why economies around the world are still vulnerable and still prone to speculative bubbles. There was no catharsis in the aftermath of the credit and financial crisis of 2008. There was no purging of excess. Efforts to bring forth the much-needed reforms have been
drowned in economic stimulus and its short-term results. Instead, we are now saddled with an economy addicted to reduced interest rates and excess money supply. Whichever way you look at it, this cannot end up well.

Make no mistake; before the economy untangles itself from this straightjacket, it has to reset itself. This has not happened in the past almost two years. Sure, it may seem so, because we have had a difficult ride, but what the global economy has gone through so far should not be equated with the resetting of the underlying structure. In other words, the Greater Recession could await us as early as 2011.

As if on cue, there is a precedent to this scenario. In 1980, first there was a mercifully short, yet very sharp recession that was also liquidity-induced, as was the Great Recession. The first bout lasted from January to July and it hit the interest-rate-sensitive sectors, such as the real estate and automobile industry, the hardest. Just like during the 2008/2009 recession, the months that followed saw interest rates plummet and liquidity taps fully turned on. It was only under the then Federal Reserve chairman Paul Volcker that liquidity was restrained, and in the nick of time, as well as at a steep price.

How did Volcker do it? He relied on “open market operations” to rein in credit, which first pushed interest rates down and led to the initial recessionary bite out of the U.S. economy. Volcker soon realized that, while liquidity in the short term was repaired, in the long term, things looked anything but rosy. Inflation had arrived and unemployment was swelling to a politically unpleasant size. To counteract that, Volcker tightened the money supply that pushed
interest rates significantly higher and effectively caused the severe recession of 1981-1982.

The economic situation of 2008-2010 is similar only to an extent and is much more complex, unfortunately. There is no detailed model to follow. Not even a similar, liquidity-induced recession of 1980 offers enough guidance. Are things beyond repair? I honestly don’t know,
but I do fear they are. I don’t know how world markets and economies can wean themselves off of reduced interest rates. I don’t know how consumers, business and governments can stop relying on debt and leverage. And, I don’t know how markets and economies are going to survive the bursting of the low-interest-rates bubble, which, let me make it very clear, will inevitably burst.