August 19, 2007
Our reliance on the property market is being cruelly exposed as the global financial crisis gathers pace.
It’s like discovering your husband downloads porn from the internet. You think you know someone and then, wham, reality hits.
It is now becoming clear that we had no idea about the extent of the financial perversity that was going on behind the marble foyers of our august financial institutions.
Reputable banks and hedge funds are now being exposed as little more than out of control ‘one-way-betters’, who were happy to bet the house on, well, other houses.
Worse still, they were doing it all ‘on margin’. This is a financial market term for putting down only 10 per cent of the value of your investment and borrowing the rest.
The problem with this strategy is that the market has to be rising for it to make sense. If the market falls 10 per cent, your entire investment is wiped out and you are under water. This is when the people you borrowed from phone up and ask for the rest of the collateral.
But you don’t have it because you have been bluffing all along. Now your bluff has been called, you have to sell other assets to raise the cash. Imagine this happening to every card player in the game.
A wave of selling then leads to more selling and more margin calls. Gamblers’ bluffs are being called every second of the day as the casino starts to implode. Everyone wants cash, but no one has any.
The IOUs of yesterday are worthless. The market now wants filthy fivers rather than highfaluting financial ‘products’ sold yesterday by snake-oil salesmen in smart Italian suits.
This lightning-quick change in sentiment, which causes an equally urgent demand for cash, is called a credit crunch. In a credit crunch, interest rates rise initially, despite the certainty that the economy – puffed up by all this borrowed money – will turn down.
Central banks, in an effort to settle nerves and bring market interest rates under control, lend money to the very banks that were lending delinquently in the first place and, on Friday, the US Federal Reserve Board, chaired by Ben Bernanke, sparked a rally by cutting the rate at which it extends this money to banks.
But in this environment, the risk is that anxiety leads to fear and the crisis repeats itself all over again. Funds have to sell shares to raise more cash as their ‘oh-so-smart’ leveraged bets fall apart.
It slowly begins to dawn – even on the cheerleaders who publish the stockbroking bilge on a daily basis to hoodwink people – that all is not well.
Selling continues. And more significantly, funds start selling shares in perfectly good companies that have nothing to do with the overvalued global housing market which is at the epicentre of the problem.
However, because the global financial markets are now so intertwined and overstretched, logical panic in one market, like property, leads to contagion in other markets as funds try to raise money to meet ‘margin calls’ elsewhere.
This is what a credit crunch looks like and we are experiencing one in the world’s financial markets at the moment.
How long it will last is anyone’s guess but, with the world’s central banks stepping in, there will be a concerted effort to calm things down, even if it only postpones the next crisis.
The reason it will only postpone rather than solve the problem is that the centre of economic activity is shifting from the US and Europe to Asia. Our manufacturing base is being hollowed out progressively, and we are too drowsy on the anaesthetic of cheap money to notice.
Ireland is an extreme example of this western malaise. We have codded ourselves into thinking that owning a few houses makes us rich and, worse still, we have misdiagnosed this easy money for economic strength. In fact, it is a sign of financial degeneracy.
Like many of the former ‘masters of the universe’ in the world’s hedge funds who have been shown up as smooth-talking gamblers rather than far-sighted investors, Ireland, as house prices fall, is also being cruelly exposed.
We have spent the past five years allowing inflation to wipe out our competitiveness. If you have just come back from holidays on the continent, you will compare prices for things like dinner in a restaurant.
Ireland, as we know, is more expensive than any other country in Europe bar Finland. That is inflation.
If dinner is expensive here, it is because costs are higher here and, what we see in restaurants, we see in all areas of the economy. Ireland has priced itself out of the game.
As a result, our balance of payments deficit is likely to hit 5 per cent of GDP this year, according to the Economic and Social Research Institute (ESRI).Don’t forget that we had a surplus a few years back.
In the past, this process could be masked because trade was not open, and the world economy was not globalised. But not any more. The opening of China has not only made the world cheaper, it has made it faster.
China has grown by 9 per cent on average every year since 1978 – that’s 700 per cent cumulatively. And last year, it overtook the US as the world’s number one place for foreign investment, with outsiders spending $54 billion in the People’s Republic. And it is moving up the value chain at breakneck speed.
The image of China as a low-cost, low-tech producer is false. Its enormous middle-class attests to a sophisticated workforce in open competition with us.
It is estimated the middle-class in China is now about 350 million people – that’s bigger than the population of the EU before the central Europeans joined in 2004.
Last year, China surpassed the US as the biggest market for that all-American car, the Buick. The demand for designer products underscores not just a consumer class, but an upper middle-class of 90 million people, the same size as Germany’s population.
Rather than accept this and try to do something about it, we are in denial, pretending that it is someone else’s problem. However, as the financial markets have shown in the past three weeks, bluffers always get found out.