Double Dipping in 2010
By Andy Xie, guest economist to Caijing and board member of Rosetta Stone Advisors
(Caijing Magazine) At the beginning of 2009, I wrote that the global economy would stabilize in the second half, and a bear market rally could start in the second quarter of 2009. I thought that stagflation would be the dominant trend for the next few years. I am still sticking to my story. The bear market rally began earlier than I expected. The reason was that major governments have been introducing subsidies for speculation. They believe that the main problems are liquidity and confidence. Hence, if investors or speculators are brought back in the game, the world economy could return to a virtuous cycle again. I think that this type of approach could lead to a second dip in 2010.
Subsidizing risk taking does inflate asset prices – mainly stocks for now. However, the hope that rising stock prices will lead to economic revival will not be fulfilled. We are in the middle of a debt bubble bursting. Rising asset prices lift the economy through boosting borrowing for investment and consumption. As the current levels of indebtedness are already too high, we won’t see rising debt demand for consumption or investment. When the dream of a quick economic recovery is dashed, stock prices will slump again, which could expose more problems in the financial system and trigger a second dip in the global economy.
The boom-burst cycle has occurred frequently in history (see Manias, Panics, and Crashes: A History of Financial Crises by Charles Kindleburger). But a synchronized global one is rare. The last crisis comparable to the current one was the boom-burst of 1920s and 30s. A synchronized global cycle requires trade and cross-border capital flow to be large. A synchronized global burst is difficult to overcome, because devaluation and export promotion no longer work. East Asia came back this way from its banking crisis 10 years ago, but it won’t work this time around.
Policymakers are frustrated that their stimuli are not working so far. The U.S. government and the Federal Reserve have spent or committed US$ 12 trillion to bail out the American financial system. TheUnited States’ budgeted fiscal deficit for 2009 is US$ 1.75 trillion, 12 percent of its GDP, but will probably surpass US$ 2 trillion. ECB, the Bank of England, and the Bank of Japan have all cut interest rates to historical lows. Their governments are already running high fiscal deficits, but employment, business confidence, and consumer confidence continue to deteriorate around the world. It’s likely that major economies suffered contractions in the first quarter of 2009 similar to the ones they experienced in the last quarter of 2008. For the whole year of 2009, the euro zone, the UK, and the U.S. may contract by 4 to 5 percent. Germany and Japan could contract by 7 to 8 percent.
This sort of global economic collapse is unprecedented. Moreover, it is difficult to see how the world will grow again when the collapse is over. Out of desperation, governments are trying to support asset prices either directly or incentivizing reluctant speculators to play. Without understanding what governments are doing, most people think that things are either getting better or will soon. After all, shouldn’t stock prices tell us about the future? This positive thinking is leading many to chase the market. This is a bear rally that will swallow many smart investors.
This phase of government-targeted asset prices began with the Fed announcing it would buy up to US$ 1.15 trillion of Treasuries, and commercial and mortgage papers. Its goal is to stabilize property prices. However, this sort of policy necessitates the Fed know what property prices should be. U.S. property prices were 100 percent overvalued relative to income. After the bubble burst, they should go down. What the Fed is doing is to shift a big chunk of the adjustment through general inflation rather than property price decline. This will impact the dollar for years to come.
The second part came with Timothy Geithner’s plan for stripping toxic assets from troubled banks. Hank Paulson, Geithner’s predecessor, wanted to focus on stripping the bad assets off the banks too. His plan didn’t fly because the market prices for the bad assets were too low for the banks to survive. Most banks have questionable assets worth more than twice their equity capital. As these assets are trading at 30 cents on the dollar, if the toxic assets are sold at market price, the banks will be bankrupt. This is why Hank Paulson shifted to injecting money directly into the banks first. The hope was that it would stabilize the financial system, and toxic asset prices would rise sufficiently for the banks to survive. This hasn’t happened.
The Geithner Plan tries to boost the prices of toxic assets by subsidizing speculation. The centerpiece of the plan was offering government-guaranteed six-to-one leverage. The current toxic asset price, 30 cents on the dollar, reflects the expected return on the bad asset. It is equivalent to a 70 percent chance of bankruptcy and a total wash for creditors, and a 30 percent chance of survival for the borrowers that support the assets. Under the Geithner Plan, an investor that puts down one dollar can buy seven dollars worth of toxic assets, meaning he could buy US$ 23.3 of toxic assets. There is a 30 percent chance that the investor gets US$ 23.3, which would give him or her an income of US$ 16.3, after paying off US$ 6 of debt. There is a 70 percent chance that he or she loses everything. Hence, the expected income for the US$ 1 investment is US$ 16.3 times 0.3, or US$ 4.9.
This plan should have boosted demand for toxic assets tremendously. Indeed, based on the simple example above, investors should be willing to pay more than twice the current price. This would save the banks. Investors would reap rewards from the 30 percent of performing asset they bought and leave the 70 percent of non-performing ones to the taxpayers, meaning that this “beautiful plan” works by robbing taxpayers. But the prices for toxic assets have not risen that much. Why? The market doesn’t think that the plan can work. Public opinion may torpedo it before it goes into action, and if it goes ahead, Congress may pass retroactive laws to confiscate the profits from the investors who participate in this scheme. Essentially, the Geithner Plan is giving speculators free money, but they are not taking it because they are terrified of the consequences.
The third piece is changing the mark-to-market rule. The U.S. Financial Accounting Standards Board has changed its rule for accounting asset value. It now allows financial institutions to value their assets according to their judgment rather than market price if they think that the market isn’t working. The market may not value asset prices perfectly, but who could do better? This rule change is to allow the banks in trouble to stop reporting losses from asset quality deterioration.
After this revision, the share prices of troubled banks rose sharply. The market was not just reacting to a superficial change. If banks can name their price for the assets on their books, they don’t have to raise capital to stay in business. This means that they might make enough money over time to recapitalize. Hence, bankruptcy risk lessens. The increased survival chance has boosted their share prices.
Isn’t it good that banks aren’t going bust? Not necessarily. Look at what happened in Japan. Its banks essentially didn’t report their losses and tried to make money to recapitalize. It kept the economy down for ten years without alleviating the capital shortfall. Changing the accounting rules doesn’t alter reality. These banks know they don’t have enough capital. Hence, they won’t increase lending and will try to milk their existing assets for profits to recapitalize. They will be a drag on the economy for years to come. The U.S. seems to be copying Japan.
In addition to U.S. policies for targeting asset prices, most other major economies are encouraging their banks to lend. What does “encouraging” mean? Banks normally lend to maximize profits by balancing risk and reward. When governments encourage them to lend, it really means pressuring banks to lower standards, i.e., taking on more risk for the same or less reward. In effect, these policies trade future non-performing loans for boosted demand today. The argument in favor such an approach is that, if every bank lends, the economy improves, which decreases non-performing assets. This sort of free lunch thinking works temporarily by inflating another bubble. Of course, it will create a bigger mess in future.
I think leakage will start to overwhelm these attempts to re-inflate the bubble. Another major dip in asset prices is likely. Further, I think that inflation will become a problem, which could cause Treasuries and other government bonds to lose value. Government bonds are the last bubble to burst. Other asset prices will bottom when this bubble deflates. This force could reverse all the air that governments are putting in now.
I have argued above for a second dip in 2010 and stagflation beyond. I want to add some comments on the nature of bear market rallies. In a structural bear market that lasts for years, stock markets can have big bounces from time to time. These bounces can be as big as 40 percent from bottom to top. Obviously, rallies of such size are mouthwatering. It is difficult for investors to stay on the sideline. I am not against playing such bear rallies, but one must remember that bear rallies are at best zero-sum games and often negative-sum games. One’s profit is someone else’s loss. Timing is everything in playing bear bounces. Getting in and out early are the basic principles. The most harmful behavior is chasing.
The last structural bear market happened in the 1970s and lasted for ten years. It is obviously difficult for investors to stay on the sideline for a decade. After all, how long does one live? This is why a structural bear market swallows more and more people through such rallies. The ones that jump in later tend to be more patient and probably smarter. I am afraid that the current bear market won’t end until it brings down Warren Buffett.
Full Article in Chinese: http://magazine.caijing.com.cn/2009-04-12/110140780.html