The economy: reasons to be miserable

June 2, 2009

Laurence Copeland- Laurence Copeland is a professor of finance at Cardiff University Business School. The opinions expressed are his own. -

Is the crisis over yet?

In the last 3 months, the Dow and the FTSE have each risen by about 25 percent, the Standard & Poor’s 500 by a third. House prices appear to be stabilising in the UK. Stress-tested and backed by seemingly unlimited government funding, the banks are lending again (if only to each other), so that 1-month libor is down to only 0.3 percent.

In the Far East, the Chinese economy may be growing again, and even Japan may have pulled out of its nosedive. The oil price has recovered from its lows.

Is there any reason to doubt that the worst is past?

No reason whatever, except the following (in ascending order of gravity):

1. As unemployment increases, defaults on credit card debt are certain to rise, reducing the banks’ ability and willingness to lend to consumers.

2. Even if the residential property market has stabilised, commercial property prices appear to be in free fall, leading to further contraction in the construction sector, more bad debts and knock-on effects on employment and investment in the broader economy.

3. The consensus view is that bank stress tests, in the U.S. at least, were based on optimistic assumptions about the depth and duration of the real estate slump.

4. In order to spare U.S. and UK taxpayers, the bailout burden has been piled on to the bond markets, which have so far proved willing to finance the massive increase in the national debt of the two countries at a cost of only 3.75 percent on 10-year Government debt in UK and 3.5 percent in U.S., which is remarkable considering that both countries appear to be heading for a debt-to-GDP ratio of 100 percent or more.

However, in addition to the recent threat by S&P to downgrade UK gilts, the spread on credit default swaps is an even clearer warning: it costs 86 b.p. to insure against a British government default, and 44 b.p. for the U.S. (compared to only about 40 b.p. for France, Germany or Japan). Outright default by Britain or the U.S. is, in my view, highly improbable.

By far the most likely outcome in the medium term is inflation, or default by stealth. This is how Britain paid the bill for World War Two and the U.S. for Vietnam. So far, however, the bond markets appear to trust the politicians to come up with a plan to pay off these debts. But they will not wait forever.

At some point, they could well take fright and try to dump UK or U.S. government debt, forcing yields up to cripplingly high levels, with disastrous consequences for the real economy.

5. Who are these bondholders anyway? A significant proportion are institutions or governments of countries which, unlike Britain and the U.S., save rather than consume, and hence have balance of payments surpluses, notably the Gulf States, Japan and, most important, China. How long will their patience last? They are locked into their massive accumulation of dollar assets, unable to exit without realising enormous capital losses. But if they decide to stop throwing good money after bad, the outcome could be a dramatic rise in interest rates and a calamitous fall in the value of the Dollar, a final convulsion in this long devastating crisis.

None of these disasters is inevitable. But if you think the worst is over, ask yourself: why is the price of gold – traditionally seen as a safe haven in times of economic turmoil – rising again?

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