Will the current unhappy situation end in a meltdown or a muddle? asks UBS’s George Magnus in his latest look at the fallout from our very own Minsky Moment.
Even if we avert a financial meltdown, which is probable if not assured says Magnus, just muddling through will be the best possible outcome.
Propositions that the current crisis is wider than subprime, will result in a durable change in credit market conditions and slow US and global growth are no longer contentious, says Magnus. Banks are in the eye of the storm:
It is well understood that large cyclical deviations in real economic activity start and end in the financial sector.
Add to this the focus on real estate assets, and you have two features which make the analysis and prediction of the turmoil more complicated.
But with markets focused on lower US interest rates as of next week, it’s important to understand that cheaper credit can’t resolve problems of credit supply, collateral values or solvency.
The economic significance of having banks and real estate at the epicentre of this shakeout and the solvency problems at the heart of the current malaise make this “unlike any of the other cited ‘liquidity crises we have known and mastered’, for example, those of 1987 and 1998 and those associated with the Millennium and 9/11,” according to Magnus.
Banks behaviour tends to be pro-cyclical, he notes - a variation of the paradox of thrift. While when one bank acts to raise its loan loss provisions, tighten lending standards and so on, it is being conservative, when they all do it, the result is rather less positive. On real estate, he notes:
Ultimately, real estate prices are important, not only because more people own more real estate than equities or bonds but because price behaviour is more extreme in upswings and downswings, longer lasting and permeates balance sheet conditions in a way that is unique among asset classes.
A slowdown is a given. What we don’t know is whether this will tip the US over into recession with ensuing global consequences, says Magnus.
And don’t believe the EM hype. The emerging markets are almost certainly not ‘above the fray’, he argues. Risks include a fuller unwinding of the carry trade, bank exposure to foreign currency liabilities, structured products or local housing excesses. Central among the risks is a sharper growth slowdown that also causes the US$ to fall more sharply and that pulls down commodity prices. Magnus writes:
Commodity prices, in fact, may be the next shoe to drop if the economic outlook continues to deteriorate.
