Alan Greenspan has said in a weekend television interview that the crisis that has gripped the Western financial system is a “once in a half century, probably once in a century type of event.”
Illustration: Jayachandran / Mint
It’s hard to judge whether the former chairman of the US Federal Reserve is indulging in post-retirement hyperbole; after all, the past hundred years have seen the financial collapse of the 1930s, the emerging markets’ debt crisis of the early 1980s and the Japanese banking disaster of the 1990s. But there is little doubt now that we are in the midst of a full-blown financial crisis, rather than one restricted to subprime mortgages.
Every weekend in the US seems to bring more bad news. This time around, it has arrived in a gush. Lehman Brothers has filed for bankruptcy. Merrill Lynch has been sold to Bank of America. American Insurance Group is also in trouble. All this follows the recent nationalization of Fannie Mae and Freddie Mac, two large mortgage companies.
These are ever-clearer signs that the great asset bubble that was inflated by loose monetary policies after the Asian crisis of 1997 and the technology bust of 2001 is finally deflating. The big question now is: What collateral damage will this inflict on the real economy?
The US economy has averted recession till now, thanks to fiscal stimulus and strong exports. But it is hard to believe that the pain there will be restricted to a few quarters of weak growth. Japan has never quite recovered from the bursting of its asset bubble in 1989, and has flitted between mild recession and feeble growth since then. Of course, it is too early to say for sure how America will survive its stress test.
US households do not save enough. They have funded their consumption binge by borrowing against their homes and stock portfolios. That was fine as long as real estate and equity prices were rising. Now, US households will have to cut their debt because the value of their collateral is dropping. They are likely to do so by selling more assets, which will further bring down asset prices and collateral values, creating the need for more asset sales and so on.
In other words, the US could be perilously close to the cycle of debt deflation that was first identified by economist Irving Fisher in the 1930s. Add to this the deleverage tsunami that has hit Wall Street. This is a combination that will test the quality of US policymakers as well as the resilience of the underlying economy.
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