BIS Warns of 'Credit Crunch'

Finance bloggers are picking up on reports that the prestigious Bank of International Settlements is now warning about the "credit crunch" that awaits us (perchance soon) in the wake of Credit Bubbles. Yves Smith, Naked Capitalism and Michael Panzner, Financial Armageddon, are patting themselves on the back, perchance prematurely (here, here) for earlier warnings. Me too. Dave Altig, macroblog, is skeptical on the other hand, concluding:

… The article contains more assertions than facts. But I think it is agreed that if there is going to be a really big spillover effect from ongoing housing woes, this is where we'll find it.

Once again, we need to wait and see who proves right and who proves wrong. In the meantime — while we struggle to live as best we can in the face of complexity, chaos, and emergence — here is a snip from the article that caused all this fuss:

Telegraph, BIS warns of Great Depression dangers from credit spree: The Bank for International Settlements, the world's most prestigious financial body, has warned that years of loose monetary policy has fuelled a dangerous credit bubble, leaving the global economy more vulnerable to another 1930s-style slump than generally understood.

"Virtually nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a 'new era' had arrived", said the bank.

The BIS, the ultimate bank of central bankers, pointed to a confluence a worrying signs, citing mass issuance of new-fangled credit instruments, soaring levels of household debt, extreme appetite for risk shown by investors, and entrenched imbalances in the world currency system.

"Behind each set of concerns lurks the common factor of highly accommodating financial conditions. Tail events affecting the global economy might at some point have much higher costs than is commonly supposed," it said.

The BIS said China may have repeated the disastrous errors made by Japan in the 1980s when Tokyo let rip with excess liquidity.

"The Chinese economy seems to be demonstrating very similar, disquieting symptoms," it said, citing ballooning credit, an asset boom, and "massive investments" in heavy industry.

Some 40pc of China's state-owned enterprises are loss-making, exposing the banking system to likely stress in a downturn.

It said China's growth was "unstable, unbalance, uncoordinated and unsustainable", borrowing a line from Chinese premier Wen Jiabao

In a thinly-veiled rebuke to the US Federal Reserve, the BIS said central banks were starting to doubt the wisdom of letting asset bubbles build up on the assumption that they could safely be "cleaned up" afterwards - which was more or less the strategy pursued by former Fed chief Alan Greenspan after the dotcom bust.

It said this approach had failed in the US in 1930 and in Japan in 1991 because excess debt and investment build up in the boom years had suffocating effects.

While cutting interest rates in such a crisis may help, it has the effect of transferring wealth from creditors to debtors and "sowing the seeds for more serious problems further ahead." …

Let's leave the last word for now to Axel Leijonhufvud, as a snip from:

vox (beta), The perils of inflation targeting: … [C]onsider American monetary policy. Does the absence of inflation since the turn of the century show that the Fed has smartly kept the interest rate in the near neighbourhood of the "natural rate"? Obviously not. More than a dozen quarter-point hikes of the short rate to which the markets paid basically no attention (the long rate not reacting) mean instead that the Bank had engaged in such an extraordinarily expansionary policy that it had lost all contact with the markets.

If the Fed was flooding the world with dollar-denominated liquidity, why was there no significant inflation? Part of the answer is that in the early-going, the Fed was fighting deflation in the wake of the ITC bust. But the more significant part of the answer lies in the determination of other central banks to prevent their currencies from appreciating against the dollar. With their exchange rates more or less fixed, the elasticity of their exports has kept American inflation in check. This short-circuits the feedback loop on which an adaptive inflation-targeting policy relies. The behaviour of the price level provided no clue to the Fed that its policy was far too expansionary.

If you run a very expansionary monetary policy and the historical conjuncture happens to be such that you get no inflation, what do you get? The answer, of course, is asset price inflation and deterioration of credit. This is the troubling legacy of policy that we are now left with.

How dangerous is it? Judgements vary and they do so because no unconditional answer is possible. What dangers will actually materialise depends on how the current financial imbalances will eventually unravel, on where inflationary pressures will first become serious, and on how the policy-makers of the major countries will respond to unfolding events. Some plausible scenarios are more reassuring than others.

The sanguine view is that securitisation and credit derivatives have made the world of finance a safer place than it used to be and that, besides, liquidity is ample all around. But it is not likely that the world will stay awash in liquidity forever. At some stage, central banks will have to mop it up or see inflation do it for them. Securitisation and credit derivatives have certainly dispersed risk through the economy and away from the banks where it used to be concentrated. But by the same token, the system has taken on more risk and we know less about where large concentrations of risk-bearing may be located. Risk spreads have narrowed in part permanently because of these new risk-sharing technologies, but in part transitorily because of the extraordinary level of liquidity. Narrow spreads have in turn induced some institutions to assume high leverage in search of yield.

A number of very large failures – LTCM, Enron, Amaranth – have occurred causing nary a macroeconomic ripple, and this is frequently cited as proof of the resilience that recent financial innovations have imparted to the system. It may be, however, that the more appropriate conclusion to draw is that macroeconomic developments are more likely to trigger trouble in financial markets than vice versa.

Comments

[Michelle Boudreau]

Credit crunch need to be minimize in order to avail satisfactory market scenario according to minimize effects of downturn economy .