By Steven Pearlstein
Tuesday, October 7, 2008
Up to now, it's been a financial crisis. This is a meltdown -- an uncontrolled and largely uncontrollable financial chain reaction that threatens serious harm to the broader economy.
The immediate problem is that the institutions that have most of the world's free cash -- banks, money-market funds, hedge funds, pension funds and major corporations -- are hoarding it and won't do the normal thing of lending to one another.
One reason is that many have taken on too much debt, lost too much money and are under pressure to use any spare cash to pay down debt and rebuild their reserves.
The other reason is that they feel unsure about what they know about the financial health of other institutions and are afraid that some of them will fail.
So what we've got is a liquidity crisis that is bigger than anyone has ever seen, on top of an insolvency crisis that is bigger than anyone has ever seen. And thanks to the explosion of cross-border trade and investment, the crisis has not only gone global but now threatens to take most of the global economy into recession.
"World on the edge," is how the Economist magazine summed things up on its cover this week. And that is certainly how things felt during yesterday's wild ride on stock and money markets.
What we now have is a set of economic and financial bubbles bursting at roughly the same time.
Here in the United States, the bursting of the residential real estate bubble punctured the first hole in the credit bubble, which in time brought an end to the corporate takeover bubble, the commercial real estate bubble and the commodities bubble. Because of those bubbles, Americans became convinced that they were wealthier than they really were, leading to a consumption binge that created mini-bubbles in autos, vacation travel and retail sales. Now those have burst as well.
The symbiotic twin of the giant consumption bubble in the United States was the giant export bubble in China and the rest of Asia. That export bubble, in turn, created stock market and real estate bubbles all across Asia and fed a global commodities bubble as well. Now that the air is coming out of the export bubble, shares on the Chinese stock market have declined 60 percent, while real estate prices in key Indian cities are in free-fall.
Similarly, you could draw a line of causality from the global commodities bubble to real estate and stock market bubbles in Russia and much of the Middle East. In Russia, stock prices are down nearly 50 percent for the year, including a 20 percent plunge yesterday before trading was halted. Unfortunately, much of that stock was bought by corporate oligarchs and their friends using loans from Russian banks, with the now-depressed stock as the only collateral. Three of the biggest banks have already required a $44 billion cash infusion from the Finance Ministry, and some analysts warn that much more will be required once sky-high real estate prices come crashing down.
Some of the froth from the Wall Street bubble made its way across the Atlantic to Ireland, which became a back-office for the U.S. and British financial service industries, attracting tens of thousands of new workers from all over Europe. Those workers, in turn, helped to create an impressive real estate bubble that has now weakened banks to the point that customers began withdrawing funds and the government had to step in to guarantee all deposits.
Other bubbles were created by complex trading and investment strategies meant to arbitrage large differences in interest rates in different economies. For years, this "carry trade" greatly distorted the value of currencies in places like Iceland, New Zealand and Australia, flooding those economies with more capital than they needed or could productively use. Now those investment bubbles have burst, the trades are being reversed and the currencies and financial systems are under extreme stress.
Because these bubbles are all related to one another, it should be no surprise that they are all popping at once. The timing, however, has created a dangerous dynamic in which selling begets more selling and failures beget more failures. No country, and no industry, can escape the effects of this process. History shows that the only way to break the vicious cycle is for governments to step in with massive amounts of money.
The immediate problem is to relieve the credit crunch by acting as a banker of last resort. Although money-market funds, for example, may be unwilling to lend to banks and other financial institutions, they are still eager to lend to the Treasury by buying its short-term bills and bonds.
So in recent weeks the Treasury and the Federal Reserve have come up with aggressive new schemes for taking large amounts of that borrowed money and lending it out on a short-term basis to banks, other financial institutions and perhaps even to corporations.
But even when the cash crunch has eased, most analysts believe the government will still have to provide the seed money to recapitalize a banking and financial system that is likely to have suffered a trillion dollars or more in credit losses. Congress last week provided the Treasury with the authority to borrow and spend $700 billion to begin that effort, while European governments have been forced to take over some of the biggest banks over there. Whether bigger and more coordinated efforts are needed will be topic A this weekend when central bankers and finance ministers arrive in Washington for the annual meetings of the World Bank and International Monetary Fund.