Bubbles usually burst – and when they do it’s messy. So why are you surprised?, wonders the Economist Intelligence Unit.
In a report, with the less-than-reassuring title Heading for the rocks: Will financial turmoil sink the world economy?, the EIU points out:
Asset bubbles almost always end in tears, and the US housing market is no exception. Banks and investors are now being punished for ignoring risk, lending recklessly and thinking property prices would always rise. As borrowers default on their mortgages, the panic has spread, paralysing parts of the financial system and threatening to undermine the global economy.
And property has always been a prime suspect when it comes to bubbles The difference this time is that the pop isn’t limited to the country in which the borrowers and lenders are based. Investors everywhere gobbled up the securities written on the US housing market – and are now paying the price, says the EIU.
The fallout rides rough-shod over the rosy view that the dispersion of risk has made the world a safer place:
Events of the past month have shown that while risk can be disintermediated by banks, it cannot be eliminated. Arguably, it migrates to elements of the financial system, such as hedge funds, insurers and pension funds, which are less qualified to manage it. And banks, which had been thought to have become safer as a result of the disintermediation of risk, now face increased risk exposure.
Under the EIU’s main risk scenario, to which it assigns a 30 per cent probability, monetary policy would fail to avert a US recession, the fallout from which would be felt around the globe. Waning confidence would prompt ongoing falls in risk assets prices, with a 20 per cent peak to trough fall in equities plausible, says the EIU. Banks, through margin requirements, will force the liquidation of assets. “At its worst, this self-reinforcing trend could see prices chasing each other down across assets classes in a debt deflation spiral,” the report adds.
US growth would slow to 0.2 per cent in 2008, predicts the EIU, while companies around the world would suffer as higher risk premium and tightening credit began to bite – while export-orientated companies would cut back on investment as US private consumption slumped.
What then are the alternatives? The EIU’s central forecast (The Good), with a 60 per cent probability, is that the impact of the tremors in the financial markets are contained by policy action.
We believe central banks have learned important lessons from past asset price bubbles, and will not hesitate to pump funds into the economy to cushion a slowdown in growth.
The Bad, we’ve covered. But there’s also The Ugly:
Should the US enter recession, another, darker scenario arises: that corrective action fails, and severe economic repercussions cascade from the US into the world economy with devastating effect. We attach only a 10% probability to this outcome, but the potential impact is so severe that it warrants careful consideration.