Recent rescue missions by the Federal Reserve have spurred creativity in bloggers’ corners. One came up with a helpful list of collaterals such as the firstborn child of the borrowers or their mothers, a copy of Shakespeare’s first folio, gold jewellery and manure (macro-man.blogspot.com/2008/03/secret-fed-memo-recovered-by-macro-mans.html) the next time the Federal Reserve wants to lend to financial institutions. Another imagines Asterix and Obelix rushing to the Fed for funds to save their village from being taken over by the marauding invaders (alzahr.blogspot.com/2008/03/asterix-obelix-at-federal-reserve.html). More soberly, economist Paul Krugman worries the Fed can’t fix all the problems of the American financial system and that ugly economics would spill over into ugly politics, particularly for the next US president (“Betting the bank”, The New York Times, 14 March).
Perhaps, their humour and anger are manifestations of their helplessness at the fast and vast unravelling of the US economy before their eyes. On Friday, Bear Stearns had to be rescued by the Fed through a back-to-back non-recourse loan facility extended by JPMorgan. That is, JPMorgan provides the funds to Bear Stearns and it recoups the money from the Federal Reserve Bank of New York (FRBNY). If Bear Stearns defaults, FRBNY cannot recover it from JPMorgan.
It is hard to sit in judgement on what the Fed did, even though it means almost no financial institution in the US is too small to be allowed to fail. That is an indirect admission that they are in the dark about the extent and depth of the linkages among these institutions and the consequent fear of systemic collapse even if one small pin is removed from the edifice. No central bank governor would want to entertain even the smallest probability of a systemic collapse on his watch. The real issues are different. It is the utter lack of accountability and credibility and the indifference to both.
Standard and Poor’s (S&P), and Moody’s are yet to downgrade 74 of the 80 AAA-rated residential mortgage -backed securities in the ABX Index though they long ceased to fulfil the requirements of that high rating, even before these were tightened by S&P and announced with much fanfare.
Insurance firms and banks now wail at the mark-to-market requirements demanded of them by auditors. That is patently unfair. When the market for the complex securities was open and they could be sold at grossly inflated prices, market participants did not demur. They took the returns and ignored the risk. Now, the market is pricing in the risk and they do not get the return. It is perfectly symmetric.
Thus, the potential risks in the coming years are that the policies adopted and solutions offered are such that they would raise the US’ fiscal deficit and inflation substantially and weaken the dollar as well. They would heap an intolerable burden on the rest of the world that’s already burdened by the surge in raw material costs and is reluctant to let currencies appreciate for fear of letting exports—the only source of growth—collapse. On its part, it is not clear that the US would handle a long economic stagnation as well as others did during the last global economic downturn. One just has to cast one’s eye back to the early 1990s when Japan, in the wake of the burst of colossal equity and real estate bubbles, also faced—thanks to the US—a relentlessly appreciating currency. In two of its worst growth episodes, 1992-94 and 1998-2002, the yen strengthened significantly and Japan bore it stoically. The country’s social stability remained mostly intact.
In fact, the rest of the developed world bore the costs of a US recession and weak dollar in the early 1990s while Finland, in particular, bore the costs of the US’geopolitical triumph. Their problems did not matter so much for the world as these countries did not have global reserve currencies and their global financial leverage (exemplified by the volume of derivatives volume as a percentage of GDP) was minuscule. Further, in that episode (1989-1992) of exceptionally below- average global growth, the CRB Index of raw materials dropped 25% from peak to trough.
How well would America and Americans, used to debt and asset bubble financed lifestyles, handle the transition to prolonged low and stagnant growth and rebuild savings?
China has a disproportionately large influence on commodity prices. But it remembers the fate of Japan, and Tibetan unrest is a case of bad strategic timing. China would play hardball on yuan revaluation. It is bad both for China and the rest of the world. All of these suggest that geopolitics will exert a larger influence on the world economy than in recent years. More than anything else, that is the powerful argument in favour of precious metals in portfolios today.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org