After the Crash of 2008. Now What?

With the immediate threat of catastrophe behind us, we have some breathing space for the real recovery to begin and for banks to start acting like banks and lend again. This will not happen overnight. But it will happen.

THE CRASH OF ’08 CAME IN A YEAR of four distinct but linked crises. There was a fuel crisis, where oil prices soared to almost $150 a barrel, accompanied by a food crisis, with rioting and export controls as wheat and rice prices tripled. The bursting of the housing bubble and the unraveling of the sub-prime mortgage market then produced a financial crisis, which came in waves, starting with sharp falls in asset values, which raised alarming doubts about the solvency of major banks. This provoked a liquidity crisis as banks almost stopped lending to one another, which led to a credit crunch as the frightened banks cut lending to usually reliable borrowers in the manufacturing and service economies.

With the bankruptcy of Lehman Brothers in September, a panic began to grow. The decline in asset prices and the reduction in consumer spending turned the slowdown into a recession that hit the G-7 industrialized economies and then spread more widely. In early October 2008, the world was approaching a catastrophic failure of the banking system. The decisive step was taken in Britain, where the government announced that it would guarantee its banks with unlimited credit and was, in effect, prepared to nationalize them. The U.S. and German governments followed with similar guarantees, which were then backed by finance ministers at the G-7 meeting in Washington on October 11–12.

We have passed the immediate threat of a catastrophe. A global banking meltdown is now unlikely, although we were dangerously close. This was the nearest we came to a Creditanstalt moment, named after the Austrian bank that failed on May 11, 1931, the event that most European historians consider the impetus that forced Britain off the gold standard and launched the Great Depression in Europe.

The parallel mass bailout of the British, European and American banks with the prospect of some $2 trillion in public funds, means that there will probably be no such Creditanstalt moment again. But there is still plenty to worry about.

Crocodiles in the Swamp

Although there are lots of reasons to be optimistic, there are still a lot of crocodiles in the swamp, starting with the housing market, where three million homeowners were estimated to be at risk of foreclosure after defaulting on their mortgage payments. This has been eased by two factors: cuts in interest rates have reduced the expected increases in variable mortgage payments; and individual banks have agreed to modify repayment terms (Citigroup and Bank of America) or promised to suspend foreclosures (JPMorgan Chase). But then there are the growing numbers of credit card defaults and the unresolved credit default swaps. These total more than $50 trillion (nearly the size of global GDP), but most of these will be canceled out.

The first problem is that nobody knows the outstanding net amount and the second is that the identities of those who will eventually be responsible for the net losses are still unknown. Had these trades been done under the rules of the Chicago Mercantile Market, there would have been no such problem. Trades are instant, identities are transparent and settlement is guaranteed.1

The second crocodile is the possible return to protectionism and the consequent blow to world trade. Since it is now widely acknowledged that the protectionism of the Smoot-Hawley Act was a major precipitating factor in the Great Depression, policy-making elites around the world will resist any such moves. But the potential of populist political forces will be strong in the context of the global recession that we foresee. This is one of the questions that hangs over the administration of President-elect Obama, who promised in his campaign to review the North American Free Trade Agreement (NAFTA) and also declared that China was manipulating its currency in a way that distorted trade.

At the very least, we expect the U.S. Congress to press for strict enforcement of existing trade rules, including labor and environmental provisions and very possibly a legal complaint to the World Trade Organization (WTO) that China is manipulating its currency. The best way ahead may be to liberalize trade for specific sectors, such as IT, services, food safety and, in particular, environmental technology and equipment. It may also be possible to progress on German Chancellor Merkel’s new proposal for a transatlantic free trade agreement, but this should be an open agreement, available to all other WTO members who agree to its provisions.

More Crocodiles

There are other crocodiles that deserve watching. The growing gap in interest rates between euro bonds issued by Germany at one extreme and those issued by Italy, Portugal, Greece and Spain on the other, will put great strain on the European Monetary Union and could conceivably ruin the euro. EU governments will probably ensure that this does not happen, but the strain could be intense. There are also some concerns regarding the disruption of Iraq’s pipeline system; the prospect of military action against Iran; Chinese pressure on Taiwan; a collapse of Pakistan leading to international action to secure its nuclear arsenal; and aggressive Russian moves against Georgia or Ukraine.

An even more pressing concern is that the housing slump in the G7 countries will not be over until the backlog of unsold houses comes down to six months or less, which is unlikely to happen before late 2009. But by then, a lot of small businesses could be in trouble, as banks, conserving their cash for fear of more losses through failed mortgages, are cutting back on their usual lending. Small businesses have to meet their payrolls each month and usually rely on bank loans to cover the roughly 60-day period when they are waiting to get paid by their big customers. Without those loans, they go bankrupt.

Globally, there are mounting risks of sovereign defaults, in which countries might not be able to honor their debts. The current spreads they have to pay on their bonds suggest that Pakistan and Argentina are in real trouble, with Ukraine close behind. The political implications of a default by Pakistan, a nuclear power with a Taliban problem, needs little elaboration, and yet the market is currently pricing in a better-than-even chance of default.

World trade is unlikely to provide much relief, on the clear evidence of the shipping industry’s Baltic Dry Index, which measures bulk shipping rates. It is down this year by more than 80 percent. The slowdown is already upon us. Spending on advertising in Britain first decreased in August, fell 17 percent in September and in October the industry had the lowest rates for TV advertisements in 15 years. Nissan has slashed its Spanish workforce by a quarter after what it called “a dramatic decline” in sales. In Holland, the consumer-lifestyle division of Philips witnessed a drop in sales of 8 percent because of declining sales in India and China, which had been the group’s bright spot. The recessions of 1991 and 2001 lasted for less than nine months and were not deep. This one may well last for 18 to 24 months, and could be as deep or deeper than that of 1981, which saw a 2.5 percent drop in GDP.

The world’s economic and power balance is assuming a new shape that currently defies logic. It is bizarre that emergent economies such as China and India amass vast capital reserves when developed economies that should be saving and investing run large deficits. Along with all the other problems that come from the Crash of 2008, including the complex reshaping of the banking system and the prolonged curbing of its appetite for risk, there is another development that defies economic logic: Countries going into recession usually display weakness in their currencies, as the United States did for most of 2007 and early 2008, to its great relief. The weak dollar spurred an export boom, one of the few parts of the U.S. economy that looked healthy. But as the troubles broadened, the dollar began to rise despite U.S. weakness. Investors around the world still saw it as a safer haven than most other currencies and economies. So the stronger dollar will hurt U.S. exports and recovery prospects.

The bright side in all of this is that we will not have a new Great Depression like that of the 1930s. World trade will not be deliberately blocked and slowly, hesitantly, with little enthusiasm and even less readiness for risk, normal banking service will start to return to the G-7 countries thanks to the great bailout. But the question of how long and deep the inevitable recession will be remains.

A Prolonged Slowdown

The world is going to experience an extended slowdown. Of the top 10 economies, it is possible to feel mildly optimistic about only one: India. It is less directly connected to the world trading system than most, has a great deal of resilience in its domestic market and a vast appetite for infrastructure investment. India’s low-cost service sector in information technology will remain popular among Western companies, and it has been finding serious offshore gas reserves. So India should do moderately well. However, as it accounts for only about 2 percent of global GDP, it is in no position to act as a growth locomotive for the rest of the planet. Sub-Saharan Africa may also continue to grow modestly at the 5 to 6 percent per year it has enjoyed for the past six years, but this is contingent on political stability and healthy commodity markets, neither of which is guaranteed.

There will be parts of the world that do very badly, probably starting with those that rely on large remittances from citizens working abroad in richer countries. This will hurt Pakistan and Bangladesh, the Philippines, Central America, Mexico, North Africa and Eastern Europe. Indeed, with Europe slowing fast and Russia sinking into a serious recession with several of its economies already over-indebted, Eastern Europe could suffer a very sharp downturn.

Is There Any Shaft of Light to Pierce this Gathering Gloom?

The United States, where the trouble began with sub-prime mortgages, is a country known for its economic resilience and the heroic efforts of its consumers to live above their means. Not only does it have lots of inbuilt balancers such as labor mobility, federal government transfers of wealth between prosperous and troubled states and ease of new company formation, but it also is big enough that some region or some sector is usually doing relatively well, even in a recession. As a whole, the United States has, by late 2008, started saving again, and it was heartening that on the day the stock market looked its worst, the Google phone was launched and Amazon showed good results.

Above all, the United States has delighted much of the world by its own determination to turn the page on the Bush era and display its own daring and post-racial sensibility by electing Senator Barack Obama to the White House. There could be few more dramatic symbols of change, of no more business as usual, than the election of Obama.

The Obama victory is likely to provide a shot in the arm for the United States and much of the world besides. There will also be a great surge of long-overdue investment in U.S. infrastructure of as much as $700 billion over the first two years of the new administration. These are likely to be financed by tax-exempt bond issues and, if inflation-protected, they would quickly become highly attractive investments for global capital. (And as bonds, foreign purchases would probably not excite xenophobic reactions from what may well be a populist U.S. Congress.)

The Price of a Speedy Recovery

The second price is harder to calculate. It lies in the devaluation not only of the American brand as a model for others to emulate, but also in the reputation of liberal capitalism and free markets. By contrast, the authoritarian government of China, still preening from the highly successful Olympic Games, looks rather more beguiling to some emerging market governments. This may not last, but it will be a long time before any more is heard of that 1990s triumphalism about the inevitable success of free markets and free institutions. Even in the West, we are likely to see governments and voters express a preference for stability over competition, for jobs over profits, for full employment over high risk and high returns.

In this sense, the Crash of 2008 may trigger more profound shifts in the global system, marking the period when the West’s dominance of the global economy and its institutions was so eroded that the system assumed a new form. This seems likely to be characterized by the emergence of the Southern hemisphere as a distinct and dynamic hub of commerce and wealth creation, of South-South trade as a new locomotive of local and regional growth, and of South-South relationships as a critical new factor in global politics (see sidebar: The South Is Poised for Success).

The Medium-Term Outlook

The outlook for the medium term remains promising, with recovery by the end of 2010 a likelihood. All of the main drivers look positive. Starting with demographics, the real problem of mass aging does not hit Europe and North America until 2012, and China’s labor force does not start to shrink until 2018. All over the world, the people now entering the workforce are better educated and more technologically savvy than their predecessors. With almost 60 percent of human beings brandishing a cell phone, we are connected and we are consumers. The new middle class of China, India and the Middle East may be under pressure, but they and their ambitions are not going away.

Although oil prices have dipped below $60 a barrel, let us hope they do not drop too much further, because we do not want to ruin those new investments in alternative energy systems that are likely to drive growth for the coming decades. Thin-film photovoltaics and new high-efficiency windmills, plug-in cars and smart grids and smart appliances are going to shift us from a carbon-heavy economy toward a carbon-light economy.

The future is still glittering, provided we get through this rough patch. And that really means one thing: The governments and taxpayers who now call the shots at the banks must make sure they start lending again. The problem is that governments and bureaucrats have not often been good at picking winners to invest in. Historically they have tended to lend to those who employ the most voters rather than to those who will make the best use of the money.

That is the worrying part of the coming boom in alternative energy. Is it better to have entrepreneurs and competition and the creative destruction of capitalism deciding which new post-Kyoto technologies are going to prosper? Or are we heading into a cautious, statist era dominated by banker-bureaucrats putting public money where government ministers tell them?

Signs of an Emergent Tension

It is one thing for France’s President Sarkozy and President Bush to agree that a world economic summit should be held to consider the architecture for a new Bretton Woods system of exchange rates, based on the 1944–1945 meetings in New Hampshire where Britain and the United States designed the post-war economic system, but it will be quite another to reconcile European social democratic traditions with Anglo-Saxon commitments to free markets, even in the context of an Obama presidency. The problem is that this is not 1944, when only the British and Americans had functioning capitalist economies. They ran the non-Communist world, so Lord Keynes (for Britain and its Empire) and Harry Dexter White (for the United States) were able to assume that Bretton Woods would be accepted by the French, Italians, Dutch and eventually by the defeated Germans and Japanese. Keynes and White agreed on a dual-currency system based on the dollar and the pound, on financial institutions such as the International Monetary Fund and World Bank that would follow Anglo-Saxon rules and precepts, and a general move toward free trade through the GATT (General Agreement on Tariffs and Trade).

It will not be so easy today. The Japanese, Germans, French, Italians, Canadians, not to mention the Chinese, Indians, Russians and Brazilians, will want to help design the new Bretton Woods system. They will want roles for the yen and yuan, the euro and the rupee, the real and the ruble.

President Sarkozy has already made it clear that he wants a move toward harmonized tax systems, which means a roughly common corporate tax rate around the world along with a closure of “tax havens,” plus limits on the rewards and bonuses for executives. Sarkozy is even looking kindly on the proposal from Italy’s Berlusconi and his finance minister for a ban on hedge funds.

Addressing the European Parliament on October 21, Sarkozy proposed that European countries set up their own sovereign wealth funds to take ownership stakes (this means at least partly to nationalize) in key industries, for fear that falling stock prices will result in a massive sell-off of European assets to foreigners.

“I don’t want European citizens to wake up in a few months and discover that European businesses are now owned in capitals outside of Europe,” he said, and went on to suggest that European states should coordinate their industrial policies to ensure that Europe is a place that continues to build “ships, planes and cars.” The United States is pumping money into its auto industry and Europe should do the same, Sarkozy argued, especially since carmakers are being forced to reorganize their production systems in order to comply with climate change targets.

“We can’t be naïve, we must protect our industry,” he went on, adding that Europe needed a new governing system to coordinate industrial and economic policies within the euro zone. “We don’t have any economic government worthy of the name. We can’t go on like this.”

It is not easy to see how any U.S. president could go along with quite such an overtly statist and social democratic system, which dismantles a great deal of the free market system and installs government in the driver’s seat. This serves as a crucial reminder that politics are going to become a potent policy driver as the financial crisis evolves into a global recession.

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