THE GREAT RECESSION, THE EUROPEAN FISCAL CRISIS AND LESSONS FOR PAKISTAN. Part 1: Background, The Roaring 90s and the rise of leverage


By Kashan Wali, exclusive to the PTH

Today is May 08, 2010. As I write these line it occurs to me that this weekend is one of the most critical weekends as the seven month long crisis that started with initial doubts about Greece’s ability to pay off the massive debt that Greece had accumulated. The world nervously watches the European debt crisis morph into a contagious financial nightmare. Investors are worried that indebted nations like Greece, Portugal, Spain and even UK have accumulated too much debt too soon.

Coming on heels of the subprime crisis in 2007 and 2008, the world economies and the financial system are still in the recuperation phase from the wounds inflicted from the subprime crisis and the subsequent Great Recession afterwards. Below, we examine the European debt crisis in more detail. We will also look at the lessons for Pakistan and other emerging countries. There are a lot more similarities between the Greek tragedy and the Pakistani fiscal conditions. For those who do not learn from others mistakes end up being others down the road.

But first let’s take a step back to the subprime crisis that had the fiscal implications for the United States and Europe. Even before the subprime crisis, let’s examine the roaring 1990s that were a direct result of the massive globalization unleashed with the arrival of the internet. This was an important decade as two most populous countries properly entered the global economic arena for the very first time. They were China and India. For the next two decades, we see an explosive growth in the world economic output, globalization of trade, fall in industrialized world inflation, falling yields and the rise of phenomenon called the “leverage”. A few decades from today, we may exclaim what a shame that such prosperity became a victim to excessive leverage and regulatory failure. Yet we have countless examples of this reckless behaviour throughout the human history.

Roaring 90s and the rise of leverage

The subprime crisis coming out of the United States was rooted in two fundamental reasons: 1) imperfect regulation of the financial industry 2) Hugely indebted financial industry holding bad assets as underlying collateral.

It was a shame that subprime crisis was able to derail one of the most vibrant economies of the last 60 years across the globe. Throughout the 1990s and the 2000s, the United States was able to gun its economic engines at full throttle forward. Rising productivity, innovation, a vastly mobile human and information capital, combined with a definite move towards information based services industry resulted in low inflation, higher GDP growth rates and lowest unemployment rates in the world history.

The US real GDP (taking out the yearly inflation) rose almost 60% between 1990 and 2006. This is a remarkable number; the world real GDP (again without the inflation effect) rose during the same time by 55%. However, remember the United States was the biggest economy in the world (accounting for 26% of the total world GDP, the gross domestic product). Bigger entities have harder times maintaining high growth rates. Here is another way to think of the tremendous economic progress of the US during that time period: the US economic growth of around 4.80 trillion dollars between 1990 and 2006 is more than three times the total economic size of the former USSR. The increase in the size of the US economy during that time was just less than the combined UK and German economies by the end of 2006.[1]

It took a massive miscalculation from the US financial regulators in the late 1990s to start the chain reaction that culminated in the subprime crisis that began in earnest in 2007. First, the United States abolished the key provisions of the Glass Steagall Act. These provisions prohibited the banks from holding other financial institutions that trade in financial markets. o understand why banks are so important and critical to the national economy let’s look at their role.

Banks are the critical conduits of financial system. They act as savings institutions for individuals, and use those saving deposits to extend loans to businesses in need of liquidity. Traditional banking by definition is a conservative system; banks usually pay less yield to their customers on the saving deposits, and charge a higher amount on loans they extend to the borrowers (individuals or businesses). The loans that banks extend to their customers are usually backed by a tangible collateral (existing inventories or assets).

The Glass Stegall Act wanted to keep banking conservative. It was enacted in 1932 as thousands of banks failed; some of them due to their trading activities in the financial markets. It was therefore looking to separate the banks from the investment management and trading firms. The investment and trading firms look for trading opportunities in the stock markets (equities), bonds (fixed income), currencies and commodities. They take calculated risks to generate returns.

Humans have traded in financial instruments for thousands of years. Finance form the bedrock of societies throughout the ages. The growth of financial markets over the last 200 years has been a direct consequence of the exploding productivity and the corresponding wealth that humans started generating as technology started allowing them to produce more at a fraction of a cost before. As capitalism started looking for allocating capital across the globe, markets started offering various opportunities to savvy investors who were seeing imperfect pricing that was appearing across different asset classes or countries. By definition, a similar asset should be priced the same between two exact same countries if there are no trade barriers. Even accounting for transportation costs and country specific differences, it can be quantified how much the asset price should differ between the two countries. As information flow started accelerating with the advent of phone, telegraph and wireless, the trading markets started going global and started exploiting these trading opportunities.

The advent of the internet changed everything even more radically; now the whole world was the proverbial playground for international investors. Big asset management firms started springing up in North America, Europe and Asia as internet propelled another age of information technology driven prosperity. The same technological revolution, along with the growth of rising superpowers like China and India were resulting in rising output at lower costs, resulting in lower inflation across the industrialized world. The same technological revolution was compelling hundreds of thousands of more investors to look for existing opportunities, resulting in falling yields across the globe and relatively less outright opportunities.

You would think that this is a natural consequence of globalization; falling inflation, and better standard of living. Yet what many did not properly anticipate was the fact that assets were not generating double digit returns. Bond yields in the industrialized world fell from high teens to below 5% as central banks began understanding inflation dynamics a lot better. Even 30 year bond yields were below 5% for US and European countries for the first time in 50 years. The era of low inflation in the first world had truly begun in the 1990s. Financial market was experiencing the same phenomenon that a mature business industry faces; as competition increases, profits fall. Yields drop when markets are open for all investors. With low yields, came stiffer competition to remain profitable. Darwin may have developed the theory of natural selection for the evolution of various species; yet this theory plays out daily in the financial markets. It is not the biggest who survives; it is the fittest and the smartest who survives in the financial competition.

To juice up the yields, investors started increasing paying attention to a tool that has been with humans for the time immemorial; leverage. Leverage is simply borrowing for new opportunities using the existing assets that an investor already holds. Leverage itself is like any other useful financial tool, if applied with prudence. If you borrow 20% of your assets at a reasonable interest rate against a stable asset to avail of a good opportunity, you can increase the profits with the same asset base. The same asset base produces more when you can borrow cheaply against it.

There are however three critical aspects of leverage; first it requires excellent liquid assets; you can only borrow against something that is useful for the other investor. Second, there is a limit up to which you can borrow against your assets. There are only so many guaranteed opportunities in the world that can compel you to put up your house as a collateral against any loan. Usually, regular non financial businesses (manufacturers, retailers, consumer products makers) rarely borrow more than 50% of their asset values.

Third: leverage can sure juice up the returns. But it can work in reverse as well. If leverage produces 20% returns, it can also produce equally negative 20% losses as well. And if investors are not careful with the leverage on their books, it can come back to haunt them badly.

Remember these three critical aspects of leverage. All of them conspired to form most of the financial crises that humans have faced throughout the last 600 more documented years. Subprime crisis was no different. The roaring 90s with tepid inflation and high rates of growth was making investors complacent. Nothing could go wrong they reasoned. What they forgot was what they were holding was not as good as they thought it to be. What they also did not know was that they were holding too much debt against their substandard assets.


Tuesday: The Sub Prime Crisis of 2007


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