Lessons from emerging economies and Japan
The US - and, for that matter, parts of Europe - is experiencing the kinds of problems associated with emerging economies, according to some economic analysts. It is easy to see why. The sub-prime market is a market where creditors lend to very risky...
The US - and, for that matter, parts of Europe - is experiencing the kinds of problems associated with emerging economies, according to some economic analysts. It is easy to see why. The sub-prime market is a market where creditors lend to very risky borrowers, in much the same way as investors have poured money into sometimes risky emerging markets.
The growth of the US sub-prime market, in turn, depended on the increased participation of foreign investors, many of whom snapped up mortgage-backed securities in ever-larger amounts. Judged by its widening current account deficit in recent years, the same is true in the UK, too. Emerging market bubbles, of course, are also associated with heightened foreign interest.
And, as banks and other financial institutions have seen their reputations shredded in recent months, some would argue that crony capitalism - which was rife in parts of Asia in the mid-1990s in the run-up to the 1997 crisis - has also been widespread in the US.
The similarities, though, are not just restricted to the experience of emerging economies. Worryingly, the US and UK experiences increasingly resemble Japan's economic and financial progress at the beginning of the 1990s.
It is often forgotten that, at the end of the 1980s, Japan was considered to be something of a miracle economy. Most economists thought Japan's output would be able to grow through the 1990s at a rate of between three and four per cent a year. With falling equity and land prices and with failing banks, these hopes floundered. As the decade progressed, Japan experienced an unwelcome dose of deflationary reality.
Despite all this historical evidence, there has been an institutionalised denial of financial dangers in the US, the UK and elsewhere in the industrialised world. The warning signs stemming from the experiences of the emerging markets and of Japan were simply ignored.
At the heart of the problem is an insistence at the macroeconomic level on the pursuit of price stability without any real reference to other signs of economic imbalance. For much of the late 1980s, Japan successfully delivered price stability, yet this achievement did not prevent Japan from having one of the biggest financial bubbles of all time. Much the same story applies to many of the Asian countries which succumbed to economic and financial collapse in 1997 and 1998. Before the meltdown, these countries ran budget surpluses. Their inflation rates were low. What could possibly go wrong? As it turned out, many Asian countries had borrowed heavily from abroad, reflected in widening current account deficits. The foreign inflows, in turn, were often invested in property ventures.
Then there are the similarities with Mexico's bubble in the 1990s. Mexico did well for all sorts of reasons at the beginning of the 1990s but one key source of external support was the advent of very low interest rates in the US, put in place by a Federal Reserve keen to deal with America's early-1990s credit crunch. Low interest rates encouraged capital to leave the US. Some of it ended up in Mexico, adding fuel to the growth rate south of the border.
Low interest rates have also played a role this time around. Following the collapse in stock prices in 2000 and 2001, the Federal Reserve slashed interest rates in response to the economic chill pervading company balance sheets. Having borrowed too much through the 1990s' boom, companies chose to repay debt. The Federal Reserve feared that a sudden increase in corporate saving might throw the US economy into protracted recession.
But the consequence of lower US rates fuelled extra borrowing from US households: at the margin, much of this additional borrowing was of the sub-prime category, providing a link with emerging market crises of old.
Spotting economic and financial bubbles is no easy task. To pretend, though, that bubbles are confined only to emerging markets is plain folly. They are a persistent feature of capitalism, whether crony or otherwise. Some bubbles might arguably serve a useful purpose - technology-related bubbles, for example, help to steer resources into the most socially-useful areas of economic activity (railways in the mid-19th century, computers in the late 20th century). Others might not cause too much lasting damage, particularly if the authorities are able to clear up the mess in a bubble's aftermath.
Bubbles related to property, though, are almost always bad news. Whereas new technologies can add to the level of well-being, property speculation too often diverts resources away from welfare-enhancing projects towards short-term monetary gain.
Most emerging market crises are violent affairs, associated with savage losses of activity in the first one or two years. That is less likely in the US this time around because of the dollar's status as the world's reserve currency. Unlike most of the emerging economies, the US borrows from abroad in its own notes and coin. When things go wrong in the US (the housing crisis is currently the biggest single problem) it is initially a bigger challenge for the overseas creditor - who discovers that the domestic value of his dollar assets is beginning to decline - than for the domestic debtor.
But that story only works for a while. Foreign creditors are now avoiding US assets like the plague, so US banks have been left with all manner of low grade assets. The counterparty risk associated with this has been instrumental in explaining why the US financial system is today in such a parlous state, and why the US economy is now threatened with a multi-year period of low growth and high unemployment.
This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
The growth of the US sub-prime market, in turn, depended on the increased participation of foreign investors, many of whom snapped up mortgage-backed securities in ever-larger amounts. Judged by its widening current account deficit in recent years, the same is true in the UK, too. Emerging market bubbles, of course, are also associated with heightened foreign interest.
And, as banks and other financial institutions have seen their reputations shredded in recent months, some would argue that crony capitalism - which was rife in parts of Asia in the mid-1990s in the run-up to the 1997 crisis - has also been widespread in the US.
The similarities, though, are not just restricted to the experience of emerging economies. Worryingly, the US and UK experiences increasingly resemble Japan's economic and financial progress at the beginning of the 1990s.
It is often forgotten that, at the end of the 1980s, Japan was considered to be something of a miracle economy. Most economists thought Japan's output would be able to grow through the 1990s at a rate of between three and four per cent a year. With falling equity and land prices and with failing banks, these hopes floundered. As the decade progressed, Japan experienced an unwelcome dose of deflationary reality.
Despite all this historical evidence, there has been an institutionalised denial of financial dangers in the US, the UK and elsewhere in the industrialised world. The warning signs stemming from the experiences of the emerging markets and of Japan were simply ignored.
At the heart of the problem is an insistence at the macroeconomic level on the pursuit of price stability without any real reference to other signs of economic imbalance. For much of the late 1980s, Japan successfully delivered price stability, yet this achievement did not prevent Japan from having one of the biggest financial bubbles of all time. Much the same story applies to many of the Asian countries which succumbed to economic and financial collapse in 1997 and 1998. Before the meltdown, these countries ran budget surpluses. Their inflation rates were low. What could possibly go wrong? As it turned out, many Asian countries had borrowed heavily from abroad, reflected in widening current account deficits. The foreign inflows, in turn, were often invested in property ventures.
Then there are the similarities with Mexico's bubble in the 1990s. Mexico did well for all sorts of reasons at the beginning of the 1990s but one key source of external support was the advent of very low interest rates in the US, put in place by a Federal Reserve keen to deal with America's early-1990s credit crunch. Low interest rates encouraged capital to leave the US. Some of it ended up in Mexico, adding fuel to the growth rate south of the border.
Low interest rates have also played a role this time around. Following the collapse in stock prices in 2000 and 2001, the Federal Reserve slashed interest rates in response to the economic chill pervading company balance sheets. Having borrowed too much through the 1990s' boom, companies chose to repay debt. The Federal Reserve feared that a sudden increase in corporate saving might throw the US economy into protracted recession.
But the consequence of lower US rates fuelled extra borrowing from US households: at the margin, much of this additional borrowing was of the sub-prime category, providing a link with emerging market crises of old.
Spotting economic and financial bubbles is no easy task. To pretend, though, that bubbles are confined only to emerging markets is plain folly. They are a persistent feature of capitalism, whether crony or otherwise. Some bubbles might arguably serve a useful purpose - technology-related bubbles, for example, help to steer resources into the most socially-useful areas of economic activity (railways in the mid-19th century, computers in the late 20th century). Others might not cause too much lasting damage, particularly if the authorities are able to clear up the mess in a bubble's aftermath.
Bubbles related to property, though, are almost always bad news. Whereas new technologies can add to the level of well-being, property speculation too often diverts resources away from welfare-enhancing projects towards short-term monetary gain.
Most emerging market crises are violent affairs, associated with savage losses of activity in the first one or two years. That is less likely in the US this time around because of the dollar's status as the world's reserve currency. Unlike most of the emerging economies, the US borrows from abroad in its own notes and coin. When things go wrong in the US (the housing crisis is currently the biggest single problem) it is initially a bigger challenge for the overseas creditor - who discovers that the domestic value of his dollar assets is beginning to decline - than for the domestic debtor.
But that story only works for a while. Foreign creditors are now avoiding US assets like the plague, so US banks have been left with all manner of low grade assets. The counterparty risk associated with this has been instrumental in explaining why the US financial system is today in such a parlous state, and why the US economy is now threatened with a multi-year period of low growth and high unemployment.
This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.