December 16, 2007
Worrying events in the US, added to an already paranoid financial sector following the sub-prime crisis, have left market traders in a state of anxiety.
In July 1998, the International Monetary Fund (IMF) issued a $10 billion loan to Russia to assist the delinquent Yeltsin government, as a result of an economic crisis that had been building for months.
Gullible market players took this loan as a sign that the corner had been turned. They contended that such intervention could only stabilise things. In contrast, I got a call that morning from an old market hand, who had seen it all before, who told me: ‘‘David, sell everything, this is your last chance.” He was on the money. Russia defaulted three weeks later.
There was an eerily similar reaction in world financial markets to concerted intervention by the world’s central banks last week. The banks, worried that this credit crunch is not easing, pledged to inject money into the system to try and bring down interest rates.
Normally, such a sign of official muscle would be enough to steady nerves, but these are not normal times. The opposite occurred. Investors regard the central banks’ intervention as either a sign of panic or a sign that the balance sheets of banks are much ropier than even the most pessimistic bear had imagined. As a result, the intervention prompted a sell-off, confirming the suspicion that we are not out of the woods yet, by any means.
As we noted a few weeks back, the watchword in the banking world is ‘guilty until proven innocent’. Everyone knows that there is more horrible sub-prime and other derivative-related crud on the balance sheets of some large banks, but because the banks have been evasive, no one knows for sure where the toxic stuff is.
So the essential lubricant of the financial system – liquidity – has dried up, because trust has evaporated. You lend to people you trust and, if you don’t trust them anymore, you demand a higher risk premium for the pleasure of lending them cash. This ephemeral quality – trust – is what the central banks are trying to resuscitate.
So, the financial markets arena has become a large game of pass the parcel. No bank wants to be the one that lends to the other bank with the huge sub-prime losses. The banks are desperately trying to pretend that they trust each other, while at the same time minimising the potential risk of any inter-bank loan, by trying to lay off that risk to someone else.
When everyone was confident, there were lots of banks happy to ensure that the system of loans, repackaged loans and syndicated loans worked well. But now, the chain has broken, and the central banks are finding that trust is an expensive and elusive commodity.
There can be little doubt that this crisis will pass, but the question is when. Last week, another unpleasant visitor made itself at home. In the US, the epicentre of the problem, the data on inflation is worrying.
Not only is inflation rising, but the financial market knows that, with this rise, the central banks will not cut interest rates indefinitely. This is the catch-22 situation in which the global economy finds itself. After ten years of a boom, inflation is rising, productivity falling and the bad loans of yesterday are being exposed.
Last Thursday, producer price inflation data in the US revealed that producer prices in November rose at the fastest monthly rate since 1973. (This is the sort of stuff economists are trained to look at, so bear with the nerd in me.)
American producer prices – the prices manufacturers pay each other for materials – are now rising at 7.2 per cent year-on-year. This is very worrying. Worse still, the pace of inflation has picked up dramatically in the past three months.
Since the credit crunch began, if we drill deeper, we will see that American inflation is rising by an annualised 22.6 per cent.
Since August, prices for what the Americans call ‘‘crude materials for further processing’’ have risen at an annualised rate of 42 per cent – now that’s what you call inflation.
And it’s getting worse. Last month, import prices in the US, reflecting the fall in the dollar, rose by close to 10 per cent, compared with this time last year. This is the fastest growth in import prices since the 1980s.Lastmonth, the ratio of industries reporting higher prices relative to those reporting lower prices was 19 to none.
So, the US has a significant inflation problem, posing a dilemma for the central banks. How long can they continue to help the banking system without jeopardising their core objective of keeping prices down? The Fed is trapped – and the markets know this. On top of this, the US jobs market is slowing down at a frightening rate. More Americans are now unemployed than at any time in the past three years.
Taken together, the reason the financial markets are spooked is that the central banks are intervening in something that they don’t seem to understand. Take the European Central Bank. How can it – being so obsessed with inflation – credibly continue to inject money into the system on the day that European inflation hit its highest rate in six years?
These inconsistencies have undermined the central banks’ efforts and, as a result, the more they act, the greater the sense of market panic. Sometimes power is best exercised with a threat, rather than with execution.
So a bit like the halfhearted stamp duty moves in our budget (which will not work), maybe the best thing the authorities can do is stand back and, like the Rolling Stones album of 1969, Let it Bleed. Ironically, the opening track on that album – released this week 38 years ago — is Gimme Shelter, which may well be all the financial markets want for Christmas.