Interesting exchange via Gavekal, the Hong Kong-based research and investment group run by Charles Gave, the French investor/commentator, his son Louis-Vincent and Anatole Kaletsky. (Gavekal seems to be Kaletsky’s day job, the other is as The Times economic commentator.)
On Monday, in its daily client note, Gavekal suggested that the UK’s Northern Rock might be the stricken “whale” whose appearance would mark the climax of the present liquidity crisis. The hunch was confirmed, but not, Gavekal notes, “in the bearish way that we had regretfully predicted”.
We thought the British government might soon be overwhelmed by a tidal wave of money, as it was on Black Wednesday, with similarly disastrous consequences for the credibility of the Bank of England, the level for sterling and, of course, the political prospects for Gordon Brown.
Some may beg to differ, but Gavekal says the result was that Britain responded “more boldly and decisively to this crisis than anyone imagined possible 24 hours ago”.
Kaletsky, in far more discursive – and more investor-friendly – mode than reflected in his Tuesday commentary in The Times, praises the UK government’s move to guarantee all deposits – not just at Northern Rock but for all lenders – as “an unprecedented step in British history – and maybe the history of any other advanced economy”. Of course, he notes, “under the circumstances it was absolutely the right thing to do”.
Just like Alan Greenspan’s rescue of LTCM in 1998, this move marked a recognition that worrying about moral hazard is a luxury that central banks can afford only in good times. Once a financial crisis has developed, it is too late to start teaching a lesson to imprudent borrowers or punishing irresponsible lenders. The central banks’ sole concern should be to stabilise the banking system in the shortest possible period which, in practice, is also the way to minimise economic risks and taxpayer costs.
The moral hazard argument, he says, is “a matter for longer-term reflection after the banking system has stabilised”.
In Britain’s case, it will probably mean introducing some new liquidity stress-tests into prudential regulations. It will also mean replacing the absurdly outdated deposit guarantee scheme, with its £2,000 limit for 100% repayment, with a new institution modelled after the US FDIC, Kaletsky says.
The British government also comes in for its share of praise. It has “proved its pragmatism by reacting so quickly to events,” says Kaletsky.
Mervyn King, the BoE Governor, who only last week astonished the world with his puritanical sermon against “moral hazard”, has shown an admirable humility by changing his mind rapidly when the facts changed.
But, Kaletsky notes, the most important feature of what he describes as “this happy ending to the Northern Rock crisis” is what it seems to tell us about policymakers’ attitudes around the world.
Whether it’s the UK, US or recently even Europe, “we see policymakers who realise they have gone too far in squeezing the liquidity out of the global system and are now determined to stabilise financial markets and support economic activity with all available tools”.
This will surely be bullish for equities and other risk assets, which are strong enough to withstand a temporary contraction in credit for another quarter or two and a slowdown in the world economy which is now inevitable. But the global economic slowdown is unlikely to be very severe, given the monetary loosening that is clearly now in the cards.
Charles Gave responds:
“This is a very good, and timely…But we must not lose sight of the fact that the recent bull market was created in large part by the excess liquidity generated by what we had come to call the “financial revolution”. The question that most investors face today, he says, is “whether this financial revolution lives on, or whether it was a mirage?”
With its bailout of Northern Rock, the BoE has successfully avoided pushing the UK into a debt deflation a la (US economist) Irving Fisher (ie, the US in the 1930s, Japan in the 1990s, HK in the late 1990s…). And this is good news.
But harking back to Fisher’s famous “equation of exchange”, MV=PQ (frequently employed to analyse the price level effects of monetary shocks), Gave notes that most of the “extraordinary resilience” of velocity in the face of tightening central banks in recent years was linked to the financial revolution. “And especially, how the financial revolution applied to, and changed, real estate”.
As I look at it, this party is now over. Sure, a credit contraction has been avoided, and we should rejoice about that. But we also need to acknowledge the fact that the real-estate based credit expansion is over and will not restart in the US or Europe for quite a while (though it may get going with a vengeance in China, India, South-East Asia…).
However we cut it, it is hard to avoid the conclusion that, in the western world at least, Velocity will stay down. Now if V stays down for quite a while (which, as you know, is my hypothesis) then we will need a hell of a rise in M in order to avoid a decline in PQ.
In any event, let me summarize what I now believe:
1- We will not have a debt deflation (is this is why gold is going up?)
2- Nevertheless, the credit expansion phase of the cycle is over, and it will stay over in the OECD for quite a while
3- In Asia, the credit expansion may still just be beginning.
Overall, in Gave’s view, a bull market may be about to start, “but it will definitely not be in the financial assets which have been the main beneficiaries of the financial revolution and the past credit expansion”. It will be in assets that do well in the (temporary) absence of that revolution. “So far, the market is telling us to be long Asia, long large caps, long growth stocks and underweight Europe”.
Fortunately, notes Gave, “this jives with all my natural prejudices”.