Explaining the Global Financial Crisis

What are the roots of the global financial crisis, and why has it produced a sudden and shocking collapse in American confidence and economic activity?

What has really gone wrong is that that entire model has collapsed along with the global financial institutions that hot-housed it. Not only has the ceiling come down on the US household sector, but the wreckage is blocking the exits.

It is that collapse of any exit strategies that is doing the damage. Simply to retain household debt-to-equity ratios at last year’s levels will now take a contraction of around 6.1 percent in nominal private consumption spending next year. To eliminate that debt/equity ratio would need a contraction of around 25 percent - the Depression Option.

Since the problem is not the ‘normal’ Austrian one of over-capacity and deflation, the normal road to recovery – supply-side reforms and industrial consolidation to build assets and labor productivity – is unlikely by itself to be sufficient. Full-scale recovery will await the re-invention of a financial system capable of reawakening a much-abused appetite for risk.

1. First, and this is the only piece of quantifiable good news this article contains, this is not a classic ‘Austrian’ crisis of overinvestment and deflation. Or at least it fits into that model at a level of generalization so broad and long as to be analytically disappointing. Nowhere in the developed world have we seen the sort of reckless overinvestment which, for example, we saw in the 1997-1998 Asian financial crisis. Nominal capital stock is growing around 3.4 percent in the US, around 5.3 percent in Europe, and 2.3 percent in Japan – hardly the stuff of bubbles. Similarly, private sector savings deficits are not running out of control. Even in the US, the private sector savings deficit is likely to be only around 1 percent of gross domestic product this year.

These are not the sort of ratios which precipitate financial crises. We expect the balance sheet of the financial system to be a mirror image of the balance sheet of the rest of the economy. But if that were the case, the problem would not possibly have escalated so catastrophically so quickly. In fact the balance sheet of the financial system no longer principally mirrors the balance sheet of the rest of the economy. Indeed, such is the size and opacity of off-balance sheet contingent liabilities, that we can say the balance sheet of financial institutions no longer even mirrors the balance sheet of the financial system.

There was a motive for this: the expiration of the 27-year bull market. And there was the opportunity: the increasingly gothic financial structures of the derivatives market which, at a huge cost, created any yield curve you liked.

That divorce between real economy and financial system balance sheets really is a problem. It explains why, unlike any other financial crises I’ve witnessed or even read about, the problem is not that the US financial system has run out of money – the strength of the currency and government bond markets show that quite clearly. It’s simply that the institutions that can use that money either no longer exist, or can no longer be safely guaranteed to exist by the end of the financial and economic crisis.

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Reconstructing or re-inventing a financial system will take time, imagination and an appetite for risk which is just as likely to be born out of desperation as of greed. There is no way of telling when that re-invention will be made, but we can be pretty sure that those countries which nationalize their financial institutions will make the discovery later, and more expensively, than those who don’t (alas, my poor idiot country, the United Kingdom).

That, however, is an argument for another year. Right now, we need at a minimum to understand the likely scale and transmission mechanism that the crisis of global financial institutions will have on the US economy in the short to medium term.

2. In the shortest term, the data for September and October describes a collapse of confidence on an unprecedented scale. In China the data collapse told us all about an inventory-dump. In the US, there was something much worse – a collapse in confidence which, so far as I can tell, is unprecedented in recent times. We can see this best in three indicators:

First, we have a direct reading of consumer confidence from the Conference Board Consumer Confidence Index, which in October had the third-largest monthly decline in its history, plummeting 23.4 points to a just 38 – the lowest reading on record. As the chart below shows, nothing like this was seen in the recession of the early 1990s, or after the dot-com bust.

Source: Conference Board

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Second, this collapse in confidence produced an immediate reaction in a specific industrial sector -- people and businesses stopped buying cars. In September car sales fell 23 percent year-on-year, and in October they fell 24.2 percent year-on-year. in sequential terms, sales were approximately two standard deviations below the long-term trends. As with the consumer confidence index, this fall dwarfed anything experienced after the dot-com bust and anything seen during the recession of the early 1990s. No wonder the Big Three are pleading for their lives.

Source: Bloomberg, CEIC Data, ColdWater Economics Ltd

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And finally, my broad measure of domestic demand momentum, comprising employment, wages, retail sales, auto sales and construction orders also plunged off the same cliff.

Source: US Govt data, Bloomberg, ColdWater Economics Ltd

3. These are truly shocking numbers, which are not really explained simply by pointing to an absolute lack of credit. In fact, bank credit grew 4.4 percent month-on-month and 10 percent year-on-year in October, with lending up 3.2 percent month-on-month and 8.9 percent year-on-year. Even the commercial paper market outstandings rose 1.9 percent month-on-month (though they fell 16.9 percent year-on-year), and the amount of domestic non-financial commercial paper outstanding rose 5.3 percent year-on-year and 6.6 percent year-on-year. The upturn in the numbers doubtless reflects the impact of the government’s extensive rescue efforts – nonetheless, the loans were and are being made.

Source: US Federal Reserve

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If not merely the product of enforced credit starvation, what is behind the catastrophic collapse in the data? My answer is that what they reflect is the collapse not just of a specific industry (dotcom, housing, autos), or a specific income stream, or even a collapse in the stock of capital, it is a response to the collapse of a model of how households make money, how they survive financially. And to speak figuratively – and I think it helps here – what’s happened in not just that the ceiling has caved in, it is that the ceiling has caved in and has blocked the door through which people had expected to make their getaway.

4. My House, My Hedge Fund. Since the end of the Cold War, two things have happened in the finances of the US household sector. First, they have adopted a ‘my house, my hedge fund’ approach to household balance sheets, running down net credit market assets in order to buy equities. It is crucial to realise that this has been a wildly successful strategy, multiplying the net financial assets of the household sector hugely, and even allowing them to build their net financial assets as a percent of GDP. Between 1990 and 2000, the household sector’s net financial assets (ie, that includes all the debt, but excludes the value of non-financial assets such as real estate) rose from around US$10.64 trillion (or around US$43,000 per person), to US$28.2 trillion (US$102,000 per person). Following the bursting of the dotcom bubble, this retreated back to around US$20 trillion by 2003, but recovered. In September 2007, this amounted to US$31.5 trillion in total, or around US$105,000 per person.

Source: US Federal Reserve flow of funds tables

This has been probably the greatest money-making machine the world has ever seen.

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5. But it was built on household’s willingness to accept risk in a world which generally was very risk averse (particularly in Japan and Europe): ie, to take on net debt. So this is what has happened: the household sector went from having net deposits (plus bonds and commercial paper) holdings of around US$6,000 per person in the early 1990s to net debts to credit markets of, at its height in 3Q06, just under US$10,000 of net debts.

But who cares about net bank debt of US$10,000 if it has allowed you to get hold of net financial assets amounting to US$105,000? I keep stressing this, because it’s so easy to lose sight of: this was not merely a rational financial strategy for the US household sector, it was an astonishingly lucrative and successful strategy.

Source: US Federal Reserve flow of funds tables

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The only problem was that this left you with a net debt/equity ratio that hit 10 percent in 2005, but which has been worked down to around 8 percent over the last couple of years.

Source: US Federal Reserve flow of funds tables

6. In the very short term (ie, this year and for the next six months) we can estimate how the collapse of US stock prices has affected this picture.

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i) I estimate that by around now, net financial assets will have shrunk to around US$22.7 trillion, which is down 29 percent year-on-year, or by around US$9 trillion. And net financial assets per person has probably retreated to around US$74,000 – down around 30 percent, or by around US$31,000 per person.

Source: US Federal Reserve flow of funds tables, ColdWater Economics Ltd

ii) Meanwhile, since there so far has been no big net paydown in debt, net debt/equity ratios have probably jumped to 10.4 percent.

Source: US Federal Reserve flow of funds tables

7. Now what has happened, with the collapse of the (largely American) global financial institutions which facilitated this strategy, is that the strategy itself has been shown to be no longer viable. When the dotcom bubble burst, the strategy was largely to double down – using the same strategy which got you in to get you out. This time, however, that’s not possible – even the institutions which brought you to this place, have evaporated. The Stock of Shock is immense.

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8. So we’re now in a position to do some back of the envelope calculations. To get back to a net debt /equity ratio even of 8 percent would require a net debt repayment by the household sector of approximately US$615 billion, equivalent to 7.6 percent of annual compensation received by American workers. That is the equivalent of approximately US$2,000 for every man, woman and child in America. If that was undertaken in a single year, it would represent a contraction of approximately 6.1 percent of nominal private consumption spending.

To eliminate the household sector’s net debt entirely would require net repayments of about US$2.65 trillion – equivalent to almost exactly 33 percent of annual compensation received by American workers. And that’s equivalent to approximately US$8,700 for every man, woman and child. If – heaven forbid – it were attempted in a single year, we would be looking at a contraction of around 25 percent of nominal private consumption spending. This is the Depression Scenario.

Michael Taylor is an independent economist and head of the UK-based Coldwater Economics