Thursday, October 9, 2008

A loss in confidence - investor and household - prolongs recessions

Recessions with a credit crisis often last longer than recessions without one because confidence in the banking system must be regained in tandem with the economy. It takes time to rebuild investor confidence in a banking system that is seemingly broken and set for reform. Recessions with a housing bust last longer than recessions without one. Unfortunately, we have got both a credit crisis and a housing crisis, and the U.S. is set for a longer downturn than usual.


The housing market is showing very timid signs of stabilization in sales, but still, the sector has a long was to go before steady growth can be re-established. The pending home sales report, which showed an 7.4% bounce in August, is certainly good news for sales, but there is still a lot of price discovery that must be made, and home values will decline until an equilibrium is found in the middle of 2009. Further, and at least for now, credit markets are showing some signs of stabilization. Stabilization in housing and credit are positive, but the U.S. economy still has a long way to go.

According to the IMF, a credit crisis plus a housing downturn correlates with longer recessions:
“What are the consequences of the declines in house prices for the macroeconomy? Evidence suggests, not surprisingly, that the macroeconomic consequences are more adverse if they occur against the context of a weakening economy and tight credit conditions, which is likely to be the situation facing many countries at present.

Over the period 1960 to the present, recessions in advanced countries that are associated with house price busts and credit crunches are slightly longer and deeper than other recessions. The duration of a recession is more than one quarter longer in the case of a housing bust, total output loss during the recession is somewhat higher, and the unemployment rate increases notably more and for longer in recessions with housing busts.”
RW: The housing downturn has passed through to the macroeconomiy via job loss, reduced consumption, and falling investment. It is just a matter of time before those components add, rather than drag down, GDP, but that time length will be longer than under normal “recessionary” circumstances.

Are we in for a decade-long financial crisis like the Japanese banking crisis? The asnwer is: the Fed and the Treasury –with their innovative policy responses – signal no. Here is an excerpt from the Financial Times in January 2008:
“Fortunately, the Tokyo tale shows that such psychological shocks never last forever. A decade after investors’ faith in Japanese banks was so rudely shattered, these institutions are once again trusted: they can raise funding relatively cheaply and investors are willing to hold their shares.

Yet this recovery took many years, largely because the Japanese government spent years denying the scale of the problem. “The biggest lesson from Japan’s past is that bankers’ stubborn refusal to recognise bad debts and authorities’ secretive attitude amplifies the problem in the long run,” says Mr Nakamae.

So the question that haunts credit markets now is whether they will be able to regain this all-important investor faith any faster than their Japanese counterparts did. Western policymakers insist that the answer is “Yes”. They have already taken some dramatic measures: last month, for example, the European Central Bank and four other central banks injected more than $400bn-worth of short-term liquidity into the markets to persuade banks to continue lending money. “In some respects, what the ECB is doing now is similar to what the Bank of Japan did a decade ago,” says Hiroshi Nakaso, a senior official at the Bank of Japan. ‘Back then banks lost faith in each other as counterparties, but they still had faith in the central bank so the central bank became like a central counterparty.’”
RW: Will the bombing of liquidity by global central banks be enough to curb the banking crisis? It will certainly help, but counterparty trust – not with just the central bank - must be re-established, and this will take more than just money.

However, massive liquidity measures, coupled with creative fiscal policy, may get us through; TARP-like policy may be just what the doctor ordered. Although investor confidence has been lost for the time-being, a massive fiscal injection into the banking system, while lowering the balance sheet burdens, might just work...at least it is an innovative idea. The one thing that global governments are doing that Japan avoided for years is attempting to address the crisis head on. Perhaps the recovery will come sooner rather than later. Really, nobody knows, and only time will tell.

Rebecca Wilder

1 comment:

  1. Thanks for the info on Japan and their response - 1990's --

    ReplyDelete