Part I - Ponzi Schemes
“What is going to happen to the real economy after the dust caused by the implosion of the financial system settles? Will the fall-out from the financial crisis be compounded by a belt-tightening of consumers?” These concerns frequently voiced by pundits imply that the world’s economies are shaken by two concurrent and interdependent imbalances: the turmoil of the financial system and the indebtedness of the consumers.
The run-amok financial system: Caused by the packaging and umpteenth re-packaging of derivatives to a degree that nobody had any idea any more what the connection of the derivatives they were buying or selling with their underlying securities were: financial instruments were traded and nobody knew what their intrinsic value was; nor did they seem to care to analyze the inherent risks (there is risk in any financial transaction!). Of course, in many instances they would not have been able to assess the extent of the risk as the underlying security was buried somewhere underneath an inverted pyramid of derivatives. Fully aware that they were violating the Golden Rule of Banking (if you don’t understand the risk, don’t do it!) the Wall Street firms repackaged the repackaged financial instruments (thus adding another layer of derivatives and making the underlying value even more unrecognizable) and then resold the new package as quickly as possible to new takers at a handsome profit. The new owners again repackaged the hot potato derivatives and dropped them in the laps of new buyers. And so on. A typical Ponzi scheme! And everybody knows that Ponzi schemes just like houses of cards eventually have to come down! It is now coming down with devastating effects, pulling the economy with it into a deep recession. Of course, after the hardships of a deep recession the dust will settle eventually and the economy will climb out from under the rubble and – we all hope – soar like Phoenix from the ashes?
But, wait – there is another little problem:
The run-amok indebtedness of households: Consumers far away from Wall Street and its financial illusionists have been pursuing their own little Ponzi schemes: helped by low interest rates and irresponsible lending practices they rushed to buy big-ticket items and homes far beyond their means. Increased demand pushed real estate prices upwards in an ever accelerating spiral. Consumers took out second mortgages to fuel their excessive spending and sometimes third mortgages to pay the bills for the first and second mortgage.
“Irrational exuberance!” Alan Greenspan should have warned two, three or four years ago. But he didn’t – he had accused the markets of irrational exuberance more than 10 years ago and then – oblivious to the risks he had perceived in the late 90s – starting in 2002 and 2003 he himself laid the foundations for the worst bout of “irrational exuberance” in generations.
So, what does all this mean to the real economy?
Both crises will – eventually – sort themselves out. Financial crises tend to be short, deep and painful. Distortions caused by household indebtedness tend to be not quite as deep, but protracted and…painful. But, will they compound one another? – You bet, they will! In our current scenario government interventions may prevent the worst from happening, but on the other hand the financial system will take longer to flush out its toxic assets and to become healthy again. On the other front consumers will have to tighten their belts to be able to pay their bills. In addition, broad consumer segments are saddled with excessive debt which they will have to service. The banks - themselves on the sickbed for a while – will have no room for leniency, instead of helping the debtors refinance their debt-load, they will make their lives more miserable; consumers will have to tighten their belts even further, triggering a slowdown in demand followed by cuts in output, falling prices of commodities and real estate as well as generally deflationary pressures – an accelerating downward spiral.
Doom and gloom
There are those economists who say it might not turn out all that bad. Their cautious optimism is based on the following assumption: The world’s economy no longer stands on three legs (US, Japan and Europe). There seems to be agreement among leading economists that the BRIC countries (Brazil, Russia, India, China) and the oil-rich nations will continue to expand and generate demand for products from the industrialized countries. Where the economists differ is as to whether the BRIC locomotive is going to be strong enough to help soften the impact at landing and avoid an out-of control downward spin of the industrialized economies. The optimists among them are also saying that after a few recessionary quarters we will see some – albeit moderate – growth again towards the end of 2009. Let’s hope they are right.
However, nobody doubts that – as a result of all this – we are now opening a new chapter – unknown to our generation: a protracted period of no growth or slow growth with the economy slipping in and out of recession for a few years to come.