October 26, 2008

Financial Crisis: Thinking Ahead

We have today a guest, economist Joseph Halevi, who thinks ahead to the possible developments of the financial crisis. 
There is no major change in perspectives despite a lot of institutional talk, most of which is not very substantive such as that at the Beijing meeting. 
The centre of gravity of financial vulnerability is now the maze of the derivatives of credit default swaps. They are being hollowed out and, to that effect, I should mention some institutional steps, which are taken individually and are not coordinated except possibly one.
The first is by France and concerns the formation of a State financial institution with the objective of preventing take overs of French industrial companies by hedge funds, In effect this stops hedge funds from trading in firms' stocks. Many people on the "left" would like that but, whatever its merit, it does not address the compelling issue of vanishing investment plans. What it does it will allow the companies to close down and even relocate abroad or shift production to their foreign plants (it is happening with Renault which is shifting output to Roumania and Brazil), thereby firing workers, without their stocks being traded and speculated as junk stocks. The unemployed will be unemployed, period. 
In the same vein the Berlusconi government in Italy is preparing
legislation to guarantee borrowing by firms, that is to underwrite
firms' debt vis à vis banks, while banks are also guaranteed by the
Central Bank, ultimately by the ECB. The crucial issue is that firms
will borrow less because demand is evaporating, hence it does not solve the issue of labor losses nor does it guarantee a recovery. It simply protects capital from every possible direction: banks are even protected twice. 
A credit default swaps clearing house is being planned by the Euro15. In effect this means making the credit default swaps non convertible, i.e. non tradeable. This is an important event if it goes ahead. Credit default swaps were used also to 'cover' for the external deficits of the deficit countries. By rendering them non convertible the deficit countries will have to pay up, hence the external constraint will become visible and binding again (as I always thought it to be in the core of the functioning of the economy). 
On the other hand, CDS are highly toxic because they condense all the other forms of debt. They were not only used to ensure against potential default but also to make money in both directions simultaneously. Since hedge funds hold a great deal of CDS, the decisions to keep hedge funds at bay will reduce the 'value' of the CDS, hence the need of a clearing house for an orderly euthanasia of this type of paper. 
Japan and China are the only countries that have initiated policies from the spending side. Japan's new package is an extended version of that passed in July or August. Public works and some income support schemes. However it is just a "stay afloat like a dead corpse strategy" reminiscent of the 1990s when they did everything to absorb production without much success.
Japan has huge structural problems since it is the perfect Marxian
"overproduction cum disproportionality"  economy, given the size of its heavy industry and capital goods sectors. It is very difficult to bring up domestic demand to the level needed to ensure recovery. And now they are also subjected to the revaluation of the yen vis à vis the US $ without the mitigating factor of US growth; hence they experience hyper revaluation vis à vis the Euro where demand is also not doing well.
Furthermore, an important Japanese export market for heavy machinery (and thus for Japan's external surpluses, which are now dwindling), the Korean, is just drifting away because of the deep Korean crisis. Japan is really in a big blackish hole. Nothing much can be expected from those keynesesque measures therefore.
China has undertaken the only noticeable spending program. It is based on placing orders at its own heavy industry through very large programs of structural investments. But many consumption goods sectors are being affected by the fall in demand in the USA and it is difficult to see how the sectoral composition of the economy can be changed in the short, or even medium, run. Moreover if the spending programs are based on the heavy industry sectors, the slow down and actual crisis in the exporting sectors like toys etc. will exacerbate the gap between domestic production and domestic consumption demand. Thus China can find itself in a dynamic version of the Japanese situation. 
We should also expect major real crises in Latin America, given what is happening to Brazil and Argentina. The fall in oil revenues prevents Venezuela from acting as a benevolent lender. After all they helped Argentina to pay the rest of the debt by buying it themselves. Notice that through Venezuela and the energy-raw materials surpluses of Argentina, Brazil some others, the Latin America economy is more dollarized than ever. But now raw materials prices are falling and the values of the Real and the Argentinian Peso are falling drastically. They are back in a real deflation+ price cum interest rates inflation crisis. Indeed Brazil had to increase interest rates sharply to stem the outflow of capital.
India: India has the fourth largest trade deficit in the world. They make up for it through capital inflows on the capital accounts and invisibles on the current account. With the credit crunch underway the ability to make money by sending money to India will be severely limited. Hence the situation is wobbly but I think they will still expand in their own Indian style.
Notice that, in spite of all the talk about coordination there is none.
They present their trips to Camp David, Paris, Beijing as coordination, but there is nothing concretely there. Every country uses its own finances, the only common elements are: to throw money at banks and - for the USA-EURO15 relations - the unlimited unsecured and non recourse lending of $ by the US Federal Reserve to the ECB. As to the common ASEAN fund supported by China, Japan and Korea fund we should judge it
when we see it, if we will see it. I cannot possibly figure the Asean
countries being capable of managing that fund given their litigious relations, it will have to be done by Japan with China and Korea. 
The crisis is generating fragmentation in the world economy.