Archive for May, 2011

BRICs, Not Homes, Did Break Our Loans, And Empty Words Will Hurt Us

Monday, May 23rd, 2011

The prevailing narrative of the recent global financial crisis holds there was nothing more afoot than the machinations of greedy bankers, reckless subprime borrowers, and supposedly pernicious products of financial engineering like credit-default swaps and securitized loans. This toxic stew of risk is generally presented as a purely American dish, though some add a continental side, such as a Greek salad of bad debt, tossed of course by American banks.

Yet risk represents a chance of something happening, not a certainty. A crisis requires more than risk – it needs something to transform the chance of catastrophe into a reality. Given the public debate’s failure to clearly identify the crisis’ ultimate cause, we should look for something of such enormity it might be missed by those inclined to believe all ills are to be found in the petty mendacities of bankers or borrowers, and so frightening that those with understanding dare not speak its name for fear not of some hidden hand’s reprisal but rather of the actions that populaces and nations might take were that understanding to become commonplace.

As its title suggests, this essay argues that a crucial and largely neglected cause of the recent and continuing economic crises is the unprecedented disruption created by the rise of the BRIC powers (Brazil, Russia, and for our purposes especially India and China) and other emerging nations. What I am arguing is that the market rout of 2008-2009 reflected not just a crisis in banking or finance but the first of what may well be many shocks in a noisy process of discounting our collision with resource supply limits to the rate of national and global growth, constraints that are becoming ever more binding, and ever more geopolitically risky, with the continued expansion of the BRICs.

It is true that the two years prior to the market crash of 2008-2009 saw a significant increase in the issuance of US subprime mortgages. By the middle of 2008, these stood at around 10% of an over-$10-trillion US mortgage market. From August 2008 to September 2009 the MBAA reports the percentage of all US mortgages in delinquency or foreclosure rose from 9.2% to 14.4%, or about $ 1.4 trillion. In June of 2010 Fitch put the percentage of subprimes in delinquency at about 45%, or $450 million (yes, the majority were actually not delinquent). This figure implies approximately $1 trillion of non-subprime delinquent mortgages, which is to say more than twice the amount of subpime delinquencies occurred in ostensibly well-documented loans to good credits. Thus the question is begged: what triggered the defaults?

In a similar vein, the repackaging of risky loans by banks who then short those bonds may move risk around to the detriment of some hapless investors, but this does not necessarily increase the riskiness of the financial system as a whole (indeed, that banks get these loans off their books can make them more stable). Likewise, credit-default swaps are essentially insurance against the failure of a borrower to service its debt; these re-allocate default risk between market participants but cannot trigger default any more than taking out auto insurance, in and of itself, can cause a car to crash.

So for some period of time, risky loans were being serviced, swaps, CDOs and all manner of financial beasts were on the books and the sky failed to fall. Then something happened.

If one is willing to look, one can easily find that something. The over two and a half billion inhabitants of China, India, and other emerging nations, possessed of the same aspirations as those dwelling in developed North America and Europe, comprise economies expanding at eight to ten percent per year. Their appetites for inputs to production – fuel, ore, grains, indeed almost any imaginable commodity, are growing accordingly. The emerging powers’ consumption of many of these raw materials is now approaching or exceeding that of either the US or EU, which basically means that in coming years the demand for these commodities will have been increased by half with little or no counterbalancing increase in supply. Simultaneously, the rise of the BRICs has explosively increased the global labor supply, and that worker pool is becoming increasingly skilled.

By 2008, the markets, which, after all, are discounting mechanisms, began seriously reflecting not just current but future demand for raw materials, as it became clear that, contrary to their track record in the twentieth century, the BRICs were now serious about growing into first-world status. Commodities, notably oil, spiked, developed nations’ corporate margins compressed and their equity markets began to fall. In the US, the weakest, most-overextended borrowers found simultaneously filling their gas tanks and making their mortgage payments increasingly difficult, especially as they were laid off by firms attempting to compensate for higher raw input prices by cutting payrolls and outsourcing to the cheaper labor of the emerging economies. Default rates rose, squeezing lenders and tightening credit, which begot more distressed firms and borrowers, accelerated defaults, and closed a vicious recessionary circle.

That circle was also briefly deflationary; as global growth turned to contraction, the price of petroleum and other commodities was driven down. Yet less than two years after the peaks of the summer of 2008, with only a relatively anemic recovery underway, we’ve seen the prices of these same raw materials approach or exceed those earlier highs. This rebound, despite tighter regulation, exchange rules and margin requirements, should give great pause to those who’d ascribe that earlier run-up solely to mere speculation.

And indeed that’s the point: the fundamental issue of the rapidly rising demand for raw materials on the part of China, India and others is still with us. (Fortunately the B and R in BRIC are net exporters of key raw materials, and Brazil’s Tupi oil find may keep it that way in the case of the former, at least as far as petroleum is concerned. But this production is swamped by the commodity appetites of India and China.) The effect is a linkage of economic and geopolitical risk that continues to evince itself. For example, increased BRIC demand for grains (for human and livestock consumption as well as fuel) helped drive severe food price inflation in much of the developing world, helping to spark the “Arab Spring” revolutions in Egypt and elsewhere, which in turn increased the risk premium in the the price of oil, further driving inflation risks that now confront central bankers, especially in India and China themselves.

As emerging economies continue to expand, finite commodity supplies constitute ever tighter constraints to growth, limiting the global economy’s expansion rate and creating trade-offs between growth and inflation in individual nations as well as competition between nations for the resources they need to grow. Add downward wage pressure from a vast and increasingly educated emerging nation labor force to international competition for raw materials and you have a recipe for protectionism, militarism and a variety of other unpleasant “isms” that make the world a more conflict-prone and dangerous place (China isn’t building a blue water navy to cruise the Yangtze, nor is its new “over-the-horizon” anti-ship missile some sort of New Year’s firecracker). This potential may explain the reticence among leaders to address these issues in a forthright manner, but avoidance, circumlocution, focus on tangential issues and scapegoating rhetoric will only make it harder to solve the problem and increase the danger of it spiraling out of control.

To be sure, dubious risk control and the failure of key financial institutions, notably Lehman Brothers, needlessly exacerbated the disruption, augmenting it with a liquidity crisis. Note to regulators and taxpayers: when a big bank goes bust, the markets need to know the shareholders will get wiped out (attenuating moral hazard) but credit will be extended so the firm does not default on its liabilities. Otherwise, banks question each others’ solvency, and soon interbank lending and the global credit markets dry up, meaning no one can get a loan. As we’ve seen, with the return of confidence, the capital necessary to accomplish such rescues generally gets paid back quite quickly and with interest.

Likewise, monetary intervention and fiscal stimulus eventually softened the blow. Inevitably, however, the anticipation of the unwinding of these methods limits their long-term efficacy.

All of this, however, pales in comparison to the secular macroeconomic change represented by the emergence of the new economies, not only as regards the causality of the recent crisis but the challenge of managing the international system in a world where finite resources could pit nations against one another, vying for the raw materials necessary for growth while billions of new workers come into the labor force. These are not problems that can be solved solely through financial regulation or even unilateral monetary and fiscal policy. Technology and innovation may eventually relax commodity constraints through the discovery of substitutes and new supplies, while the growth of the emerging economies’ internal demand may eventually absorb much of the new labor forces’ production. This evolution could take decades, however, and in the meantime I suspect unprecedented international coordination and cooperation may be necessary to manage growth and even preserve peace. This will be a process of great complexity, but surely the first step is recognizing the problem.

What of all those risky loans, the US subprime mortgages, distressed assets on the books of German landsbanks, Irish commercial lenders, Spanish cajas and even Greek and other troubled sovereigns? It’s easy to say any asset or investment that winds up performing badly was “too risky” after the fact. Some of these financings may well have been unwise, but we must ask what happened in the world to make them implode. If the cause of the collapse is not understood even after the fact, it’s hardly surprising that the risk of it was not appreciated beforehand.

As the old saying goes, when the tide goes out it reveals all the trash left on the beach. But it is the moon that drives the tide and not the detritus left in its wake. If we fail to grasp the ongoing disruptive and potentially destabilizing effects of the emergence of China, India and other new economic powers, we may find ourselves gazing up at a very bad moon rising.