Professor Clive Thomas

The worst-case scenario: Economic shocks in the 2nd half of 2008

Recap 
In last week’s column I considered three major economic shocks/challenges which rocked Guyana’s economy during the first half of 2008. To repeat, these were the continued rise in 1) food prices 2) oil prices and 3) a speculative bio-fuels bubble, which threatened to delude the authorities into believing they had found a ‘miracle’ solution to Guyana’s energy woes. The first two challenges/shocks generated strong inflationary pressures in Guyana (through rising import prices), as well as impeded export production (through rising input costs). The former effects were compounded by the value-added tax (VAT). Government’s principal concern over this period was to mitigate these effects through various safety-net and relief packages, which focussed on its “grow more food” campaign, plant seed distribution, and aiding the development of farmers’ markets. 

Dubious economics data
Despite the obvious magnitude of these economic reverses, the official data do not fully portray their impacts on ordinary citizens. Indeed, the Bureau of Statistics had declared an inflation rate of only 5.8 per cent for the period January-June 2008. Over the same period it reported a dubious growth of real GDP of 3.8 per cent.
Remarkably these data indicate that the Guyana economy was insulated from the global shocks during the first half of 2008!  Personally, however, I remain skeptical of this. I cannot prove though that the economic data are being massaged to support predictions of the authorities as some critics argue. Nonetheless, I share the widespread agreement that the bases of our national statistical collections need to be revised and improved.

Why rising food prices cannot last
Readers may not have been fully aware of the significance of the fundamental statistical relation between the demand for food and income that I introduced in last week’s column. As I indicated then, this relation undermines (short of a global disaster that drastically limits food output), any long run tendency for food prices to rise and thereby to promote price imported inflation in net-food importing countries.
The fundamental statistical relation states that, as persons and nations get wealthier, a reducing proportion of their incomes will be spent on food. This relation holds true for all regions and cultures. Because of this demand growth cannot sustain a lasting tendency for food prices to rise. Short-term disruptions of supplies may affect prices in the short-term. With the long run trend for food productivity to rise, even if at a reducing rate, I venture the opinion that rising food prices will remain exceptional occurrences and not the rule. This means that Guyana must guard against being sucked into a ‘food bubble.’ If food prices were to rise sustainably in the future, Guyana, as an agricultural-based economy, would find considerable opportunities, not threats or economic reverses.

The fundamental relation of oil production
I should point out that there is another fundamental statistical relation at work in oil production. Oil is a commodity that is ultimately in fixed supply. It can only increase through geological time. Because of this, once the annual global output of oil (or that of any region) peaks, an inexorable and irreversible decline in output is immediately set in place. After this decline commences the price of oil will rise sustainably.
However, there is no evidence that the global annual output of oil has peaked. Nor for that matter, is there strong evidence to show that this will occur some time in the near future. Unexplained rises in oil prices (as with food) are better explained by speculation and/or temporary disruptions in their annual supplies, including stocks.

Perspective
From this perspective the twin shocks of rising food and oil prices during the first half of 2008, bad as they were, could not be sustained indefinitely. As we now observe all commodity prices are in decline, particularly oil. The immediate threat is not inflation but deflation of commodity prices.
Bad as they were, these exogenous economic reverses, which occurred in the first half of 2008, pale in comparison to those that emerged in the second half of 2008, particularly towards the end of the third quarter and all of the final quarter of that year. Here, the worst case scenario occurred.
I displayed a Schedule two weeks ago (January 25), listing the fourteen major economic shocks/challenges of 2008. Eleven of them occurred during the second half of the year. The first of these eleven was the financial crisis and credit crunch in the United States.

Financial crisis and credit crunch
As I have previously explained in earlier columns (November 2 and 9, 2008) there is good reasoning behind my consistent description of the initial finanical fallout in the USA, as constituting these two elements. The credit crunch refers to the massive and sudden freezing of loans and credit by US commercial banks. This reflected the basic distrust they had for the securities on offer from credit seekers. It also reflected a great unease about their own portfolios of assets. The latter reflected the opacity of the assets being traded on the US financial markets. These assets came to be described as “troubled” or “toxic.” As these names suggest they were too risky to acquire, at any cost. The freezing of credit brought the smooth workings of the wheels of commerce in the US to an abrupt halt.
A financial crisis is different. It refers to a regular systemic dis-order of the capitalist financial system. Here while credit continues to flow, there is a definite cyclical periodicity to these flows. This cyclical periodicity is part of the normal rhythm of capitalist expansion and contraction. A financial crisis could be triggered by any number of factors. In the era of globalization, financial crises have become more global in scope, more easily transmitted from one country to another, and involve immensely large sums of money in comparison to the value of global GDP output.

What effect did these two events, the credit crunch and financial crisis, have on the Guyanese economy in the second half of 2008? I shall respond to this question next week, but readers would have already recognized that the Guyanese authorities have been playing ostrich, pretending and perhaps hoping these US based catastrophes would simply go away.

I shall continue the discussion from this point in next week’s column.

Economic challenges in the first half of 2008: Rising food, fuel prices and the bio-fuels bubble

In this week’s column I shall begin a review of Guyana’s economic performance during 2008, principally through evaluating the impact of three major shocks and economic challenges which rocked the economy during the first half of that year. As presented in last week’s column the shocks and economic challenges during 2008 differed greatly between the first and second half of the year. Indeed, in that column, I displayed a schedule listing the 14 most important economic challenges of 2008. Three of these occurred in the first half of the year. 
2008 Budget theme
The 2008 Budget was laid before the National Assembly on February 22 and had as its theme: “Staying the Course: Advancing the Transformation Agenda.” That theme was no doubt largely guided by the uncertainty that faced the global economy in the early months of 2008.
Indeed, the Budget had recognized global economic growth of 4.9 per cent for 2007. This was, however, expected to falter in 2008 reaching only 4.1 percent. According to the Budget strong global growth in 2007 was fuelled by rapid growth of the emerging market economies (7.8 per cent for 2007), and in particular China, which grew at 11.4 per cent in that year.
During 2007, the phenomena of rising food and oil prices at the global level constituted the major external economic challenges. The general inflation rate for that year was 14 per cent. The increase in food prices, however, exceeded 20 per cent. Like others at that time, I am skeptical about the accuracy of these inflation estimates. However, I have to use them as they are in fact the only ‘official’ estimates for that year.
The ‘official’ overall inflation rate for 2007 did not accord with the anecdotal experiences of purchasers in local retail markets, particularly those spending on food items. Rising food import prices, plus the 16 per cent value added tax (VAT) on most retail items, did not square with a price inflation rate as low as 14 per cent and 20 per cent for the “overall” and food items, respectively. Nevertheless, these rates were in fact more than double those of the preceding five years!
During the first half of 2008, rising prices of food and fuel, which started in 2007, persisted. This occurrence dominated government’s policy responses in early 2008. Further, as the year went on, the price of oil reached unprecedented levels and, despite the official statistics for January to June 2008, the prices of imported food items continued their relentless rise.
Shortly after June 2008 the Bureau of Statistics had produced an estimated inflation rate that was less than half the rate for previous year (6.8 per cent for January-June 2008). I have already commented on these statistics in previous public statements and in the process I have highlighted the course of certain prices (for example, milk and milk products), which no consumer I questioned considered plausible.

Effects of rising oil prices
The effect of rising oil prices was as devastating, as the increase in food prices. Oil is the main source of energy in Guyana. Price increases have pass-on effects, since every item reaching the final consumer requires energy to produce, store, and/or distribute. In addition, rising oil prices raise export production costs (particularly in non-sugar areas such as mining), as well as personal transportation costs.
The persistence of rising oil and food prices during 2008 clearly impeded Guyana’s economic growth, development and job creation. Moreover, these two shocks were both exogenous, in that they arose from considerations beyond the control of the Guyanese authorities. Regrettably, these same authorities have sought to minimize or ignore the negative impact of external shocks and economic reverses on economic performance during 2008.

Bio-fuels bubble
As if the situation created by rising oil and fuel prices was not bad enough, the fusing of the two created a global ‘bio-fuels bubble,’ which affected Guyana. The basis of this bubble lay in the mistaken belief that rising food and oil prices in 2008 represented fundamental shifts in the global demand and supply schedules for these items! It was argued that the main causes for these shifts were 1) the spectacular growth of demand for food and fuel in the emerging market economies 2) the negative effects of global climate change on food supplies and 3) the disruptions and geo-political uncertainty in the Middle East.
I will not revisit these issues here, as I have already discussed them in previous Sunday Stabroek columns during 2007-2008. The main point I wish to reiterate now is that speculation has clearly dominated price behaviour for oil and food in the recent past. In addition, rising food prices globally are not a sustainable long-run phenomenon. The economic evidence shows clearly that as persons and nations’ income levels improve, a diminishing proportion of that income will be spent on food. In this circumstance there can be no long run sustainable improvement in the price of food relative to the price of manufactures and services. Of course, this stipulation does not rule out supply shocks in the short run, particularly those caused by bad harvests. In the case of rising food prices during 2007-2008, the evidence now reveals that there were supply shocks in the food chain, but that the main cause of price increases resided in speculation in food and commodity markets. This was also true for oil prices in that period. 
As I stated above, rising food and oil prices fuelled what I would term in retrospect as a bio-fuels bubble. Typical of such bubbles, speculation dominated the market place and players in both food and oil markets deceived themselves that bio-fuels, led by what seemed a continuous increase in oil prices, were also entering an era of continuously rising prices, growing demand and therefore increased profitability. Guyana got sucked into the bubble, with the authorities making extravagant claims about the potential of ethanol and sugar cane production as a solution to Guyana’s energy needs, export earnings, and saving on import expenditure.
The later decline in oil prices, (by about 75 per cent of its peak level of US$150 per barrel in 2008) has brought the cold harsh light of realism onto the domestic energy market and has hopefully burst the bio-fuels bubble in the making.
As readers would realise these shocks of rising food prices, rising oil prices and the bio-fuels bubble posed serious economic challenges for the economy. As we shall see, however, the effects of the later shocks, which emerged in the second half of the year turned out to be far more devastating.
I shall continue from this point next week.

How will future economic growth be affected?

V, U, or L-shaped growth curve
Following last week’s column, I shall discuss this week the impact of the financial crisis and credit crunch on the prospects for economic growth performance in the United States, the broader global economy, and Caricom. I will start the discussion on Caricom in next week’s column.
At this juncture, economists are pointing out that it makes a big difference whether the chart or curve for future GDP growth in the developed countries takes the shape of a V, U or L. In the first instance, the V shape indicates a relatively sharp decline of economic growth into recession and an equally sharp revival in economic fortunes, after a very limited period at the bottom of the curve.
In the case of a U shaped curve, as the letter indicates, the economic decline is steep and the revival, when it comes is also steep. However, the time spent in recession at the bottom of the curve is much more prolonged than in the previous example of the V shaped curve.
The L shaped curve is normally indicated as an elongated L. Here the stay in recession (after the precipitous economic decline) is protracted. The economy finds it very difficult to overcome the downward drag on its growth, incomes and employment and the recession therefore, persists.
With these possibilities the most optimistic forecast out there is that recovery from the recession in the developed economies will not be underway before the start of the second decade (2010). 

Monetary, fiscal and trade policies
It is concern over a protracted depression that drives the coordinated global effort to utilize monetary, fiscal and trade measures to stimulate global growth. Monetary measures have taken the form of reduced interest rates and the stimulation of bank lending. Global interest rates are now at record low levels. The present Fed Rate, at a quarter-of-one per cent, is the lowest rate ever for the US.
Fiscal measures have taken the form of both tax cuts and beefed-up spending by governmental authorities. The fiscal stimulus packages in the US and Europe, discussed last week, signify the magnitude of this effort. The International Financial Institutions (IFIs) have also concentrated on increased availability of funding for social, infrastructural, and poverty programmes in developing countries.
Trade measures, under WTO-guidance have been coordinated to ensure that countries do not restrict imports or subsidise exports in an effort to confer preferment or advantages to their domestic producers. Such policies are called ‘beggar thy neighbour policies’ and were major contributory factors to the prolongation and depth of the Great Depression of the 1930s.
To sum up, there can be little doubt at this stage that the global economy has already suffered major reverses in its real sectors, stemming from the financial crisis and credit crunch. Moreover, there is every prospect that these negative outcomes will intensify.

Spread of economic difficulties
Even high-flying economies with stellar growth rates have been badly impacted by the economic reverses. For example, China’s economy has had the most explosive growth over the past three decades. This growth, however, has been export-based, and dependent on the US market. The recession has already hurt sales of Chinese manufactures in the US, leading to a deceleration of China’s economic growth prospects.
There are two important barometers of expectations for future global growth. Firstly, the behaviour of securities prices on the various global stock exchanges. And, secondly, oil prices in the world market.
In so far as stock exchanges reflect future expectations about the performance of national and global economies, the trend in stock prices tends to be a good guide to the level of economic uncertainty among investors. In recent months global stock exchanges have shown exceptional volatility, even as overall indices of prices have trended downwards. Record swings in these indices have been recorded on all the major stock exchanges leading regulatory authorities to impose restrictions on investor behaviour. In the case of Russia, its stock exchange was temporarily closed!
If stock exchanges have been exceptionally volatile, the behaviour of oil prices on the world’s commodity markets has been equally extraordinary. A year ago no one would have forecast that the price of a barrel of oil would reach US$150 by the third quarter of this year. Equally, no one could have imagined that it would fall precipitously to around US$40 per barrel, in the space of a few months!
While stock exchange volatility indicates the underlying uncertainty about the economic future, the drastic decline in oil prices indicates the near certainty in the expectations of investors that the world is facing a very serious recession. With recession and the decline in economic activity, the demand for energy as an input is certain to fall. The price decline in the oil market has factored in this expectation.

Back-burner
In some ways the most disheartening consequence of the financial crisis and credit crunch and their spill-over to the real economy has been to put on the back-burner of global attention, three very crucial global emergencies.
The first of these is the food crisis. I have considered this at some length, previously in these Sunday Stabroek columns. The second is the related problem of poverty, nutrition, hunger, homelessness, and deprivation that the Millennium Development Goals have targeted for global eradication.
The third is the issue of climate change and the global commitment to secure inter-generational equity, through preserving the sustainability of the natural environment for future generations.
Next week I will continue the discussion from this point.

From financial crisis to real economic crisis

Two issues need to be considered at this stage of the analysis of the financial crisis and credit crunch. First, to consider to what extent these financial occurrences have already negatively impacted the real economy. And, secondly, to evaluate the prospects for further damage, including spill-over effects to Caricom economies.
Several considerations confirm the already negative effects on the real economy and provide a gauge to future prospects. It would be useful, however, to begin the discussion by recognising two recent policy actions taken in the United States and Europe as an indicator of these effects. 

Coordinated EU action
Despite sharp differences in the policy stances adopted by EU member states on the financial crisis and credit squeeze there was unanimous agreement to support a massive stimulus package of public expenditure to the equivalent of 1.5 per cent of the GDP of the 27 EU countries. This stimulus package is projected to complement that promised by President-elect Barack Obama after he takes office on January 20, 2009. The massive size of the EU stimulus package is a clear indicator of how seriously the authorities see the threat. This fiscal stimulus package has been accompanied by a coordinated reduction in interest rates. Indeed, in the US the Fed Funds rate has been reduced to its lowest level ever -025 per cent

Auto bail-out
The second set of actions concerns the efforts to prevent the collapse of the US domestic automobile makers. Congressional failure to provide a short-term bridging loan from the US government of between 15-34 billion US dollars to the three leading auto makers (Ford, General Motors and Chevrolet) will force the hand of the US President George W. Bush to act. Unwilling, no doubt, to end his presidency with the demise of the US once renowned domestic automobile makers an agreement will definitely be reached to provide some sort of assistance.
There should be no doubt that if the American domestic auto industry collapsed, the economic fall-out would be horrendous. Although the transplant auto sector (Japanese and European manufacturing plants in the US) would expand their production, the adverse effects on the US economy would be considerable. It is estimated that the industry, including suppliers of its inputs, car sales outlets, and finance houses account for about 10 per cent of US GDP and about 2.5 million jobs. Added to this there will be further fall-out in terms of reduced spending and tax payments by those who become unemployed and the associated firms that go out of business. 
Indeed, it is estimated that the losses in tax payments from job losses and reduced expenditure in the US economy could comfortably exceed all the current estimates of the public funding required to salvage the auto industry. In this sense therefore the situation without a bail-out of the auto firms is likely to cost the US government more than the bail-out being requested.
Other sources of damage
While the two actions discussed above signify the magnitude of the economic problems posed by the financial crisis and credit crunch, they represent a tiny fraction of the total damage already done to the US and the global economies. The US is projected to lose 2 million jobs by year end.  The rate of job losses has been increasing as the months have gone by this year, reaching over 530,000 jobs for the month of November!
As a consequence the US unemployment rate is estimated at 6.7 per cent at the end of November. This is a national average and as such it varies by region across the country. The expectation, however, is that particularly disadvantaged communities (like the north-east auto production belt) would be well above the national average. It is also expected that by year end the unemployment rate could be in excess of 8 per cent.
Accompanying these job losses there is the expected decline in tax payments, both as a result of workers losing jobs, and the decline in sales and profits for many firms. Simultaneously there is increased pressure for public expenditure on items like unemployment assistance.  Consequent to the financial crisis and credit crunch, unemployment assistance has been extended by several weeks for recipients in order to take them through the year end holidays.

Inflationary pressure or deflation
This type of demand for public relief expenditure combined with reduced tax payments put inflationary pressure on the national budget. Indeed when all the various stimulus expenditure for this budget year is totalled, the expenditure can reach to US$1.5 trillion. The inflationary pressure on the US national budget and economy will be unprecedented.
Contrarily, the major fear expressed in the US is not inflation, but deflation. Deflation is a situation in which prices are falling as national output is declining. It is one of the worst manifestations of a depression.
Although as a rule economists believe they now have adequate tools to deal with inflation, they are far less confident about these when trying to bring an economy out of a deflation. The chief reason for this is that during a deflation, psychological considerations become paramount, as the business outlook discourages private investment and consumer spending. Expanding government expenditure, without complementary increases in private investment and consumer spending cannot by itself bring an economy out of a deflation.
Already in the US consumption spending has declined significantly and so have the sales of major retail outlets and service providers. Some well-known firms have gone into Chapter eleven bankruptcy. Business losses and reduced consumer spending discourage new investment and the expansion of existing firms. The consequence of this has been a recession which is defined as two successive quarters of GDP decline
Typically, economists have only been able to statistically diagnose recessions late, after the economy has turned around and is already on the upswing. This is of course because recent recessions have been short-lived. The official data however show that the US economy has been in recession for about a year now — since December 2007. Statistically, we also find that this is the worst recession for decades. Indeed, to some economists the US economy is probably closer to a depression than a recession.
The decline in consumption expenditure is very significant because about 70 per cent of total expenditure in the US economy is consumer-based. While this present decline reflects in the main the bleak economic circumstances prevailing with increasing job losses and reduced take home pay, it has been further accentuated by the credit card squeeze.
More than any other country US consumers create debt to purchase consumption items. They in fact dis-save. The effect of a credit squeeze on consumer spending can be, as it has been, quite dramatic.

Assessing the G20 Summit responses: Weak diagnosis equals weak solutions

Overriding considerations
Except by pure chance, ultimately the effectiveness of the actions proposed by the G20 Summit held on November 15, 2008 would depend on the accuracy of its diagnosis of the present financial crisis and credit crunch that are engulfing the global community. In this regard, I would argue that, from the perspective of the developing countries, three over-riding considerations should guide the summit’s responses.
First, the need to confine as far as possible, the crisis situation that has erupted, only to those countries it has already engulfed.
Second, the need to prevent the spill-over of negative occurrences in the financial system to the real economy, where goods and services are produced and consumed for the private benefit of those concerned.

And, thirdly the need to preempt, if possible, future recurrences of such crises.
Regrettably, as globalisation has developed over the past three decades, one of its most distressing manifestations has been the periodic recurrence of serious financial crises of global proportions. Like now, each of the past crises has rocked the very foundations of private market-based capitalism on which the global economic, social and political order is predicated.
From the perspective of these over-riding considerations readers can appreciate the depth of uncertainty presently facing the global economy. To take an example, the domestic-based auto companies in the United States are blaming the present financial crisis and credit crunch for much of the immediate difficulties they face and are calling on the US government for “bail-out” support to the tune of several billions of US dollars. If help is provided to these US-based auto makers and not to the “transplant” auto sector (mainly Japanese) in the US, which has not called for a bail-out, this could be seen by the rest of the world as naked protectionism. In which case, history has shown that such inward-looking policies are always the worst policy choices from a global perspective, as they limit the spread of competitive global market capitalism.
The concern among many is that during the Great Depression (1929-33) such policies are now widely recognised as the main contributors to its prolongation over so many years.

Diagnosis
A good idea of how the G20 interprets the present crisis situation and therefore, might wish to proceed in dealing with it, can be gleaned from the causes of the crisis as they have identified them in their communiqué. Seven such contributory causes are indicated.
First, the G20 Summit blames the crisis on the under-appreciation of risks in the financial system by portfolio managers of financial institutions, particularly the banks and mortgage-lending firms.
Second, they blame the failure to exercise “due diligence” on the part of those financial firms that extended credit to borrowers.
Third, they further observe that this failure reflects a situation where financial standards were not being maintained, and indeed, they were falling.
Fourth, the decline in financial standards is reflected in crucial failures in the operations of the regulatory and oversight bodies established to prevent this from happening.
Fifth, as all this was taking place, they noted that poor management practices became apparent. And, sixthly, financial institutions got involved in excessive leverage as new instruments for structuring loans were introduced.
As a final cause, they have identified greed. This greed was exhibited by both lenders and borrowers. Lenders became involved in what was clearly “predatory lending.” At the same time, borrowers were accepting loans well beyond their means of possible repayment, based on their savings and likely future earnings.
As these causes helped to generate the crisis, insufficient global coordination of the macroeconomy, central bank actors, and trade policies allowed its rapid transmission around the world.
The G20 Summit communiqué makes the observation that between November 2001 and December 2007, the world economy went through an expansionary phase. In this period the growth of global output and incomes was strong. Capital flows around the world and among the emerging market economies (like China and India) as well as the leading industrial powers were robust. By and large, this was a period of fairly prolonged global economic stability, despite terrible political, cultural and geo-strategic conflicts.

Systemic concerns
The analysis of the causes of the crisis coming out of the November 15, G20 Summit fails to identify the systemic bases of the financial crisis and credit crunch. While each of the reasons indicated by them, as listed above, has indeed played a part in the evolution of the present crisis situation facing the global economy, these are in turn systemically related to underlying defects in the regime of private market-based capitalism, in an era of intense globalisation.
The blame for what has occurred has been placed by the G20 Summit squarely at the feet of actors and participants in global financial markets, rather than the systemic pathologies infecting the relation between the financial system, which is a product of market capitalism, and market capitalism itself.
Because of the rather superficial diagnosis of the situation, the proposed measures of the G20 Summit would not be able to prevent the recurrence of periodic crises, as globalisation proceeds. For this reason the interests of countries like Guyana would be best served if a means can be provided to de-link the defective operations of global financial speculation from the management of their external finances.
In this regard activist scholars and more progressive political leaders are calling for the creation of Regional Monetary Agreements and Exchange Rate Regimes tailored to the needs of developing countries. These mechanisms can provide for 1) external reserves pooling 2) securing temporary short-term assistance when balance-of-payments problems emerge and, 3) to reduce the need to use US dollars as the exclusive transactions medium for international trading.
Next week I will continue the discussion from this point and seek to examine some of the real economy effects of the financial crisis and credit crunch.

An abrupt about face: From the Troubled Assets Relief Program to partial nationalization

From the inception the US Treasury authorities have made it clear that the primary objective of the Troubled Assets Relief Program (TARP) is to stabilize the US financial system and free the flow of finance to business. As they see it the problem facing them is located in the accumulation of illiquid mortgage assets parked in the portfolios of the major banks. 
However, in the two months that have passed since the programme was introduced no noticeable progress has been achieved towards this objective. This has led to a dramatic turnaround in the approach of the authorities to the financial crisis and credit crunch.
Many critics have been pointing out that the TARP is providing a bail-out to the very institutions that have in their reckless pursuit of profits acquired these toxic assets. It is unfair to ask taxpayers to pay the cost of this risky behaviour. Moreover it is not only US financial firms that hold these assets, but foreign firms as well. The US taxpayer should not be asked to bail out foreign firms.
A related consideration is that the bail-out will add to the US budget deficit thereby placing inflationary pressure on the US and global economies. Additionally, the amount of funds available in the TARP is US$700B, which is only 5 per cent of the estimated value of US$14 trillion in toxic assets parked in the portfolios of financial firms.
Over the past two months the US economy and its financial system have encountered several reverses. The financial system has seen the bail-out of Citigroup bank, one of the largest banks in the country. It is now being reported that 171 US banks are at serious risk.  In the real economy the three giant US automobile makers are also seeking US government help as they face bankruptcy (General Motors, Ford and Chevrolet).
TARP’S new focus
The TARP has been re-focused to purchasing preferred stock in banks and other financial firms rather than the purchase of their toxic assets. This measure extends US government ownership over its private banking system, much to the chagrin of some capitalist ideologues.
As the US authorities themselves describe it, the new goal is:
“The direct recapitalization of troubled banks and financial institutions through federal government purchase of preferred stocks, rather than the purchase of their toxic assets. This would better protect taxpayers and prevent unjust enrichment of negligent executives and investors.’ The problem being identified here is that when toxic assets were being purchased under the TARP, the US authorities had no control over the use of the funds they released to the banks and financial institutions. Critics observed that in practice these funds were being passed on for the exorbitant remuneration of the very executives and investors who had created the problem in the first instance. In some instances the banks and financial institutions have also been using TARP funds to acquire smaller and/or weaker firms.
What the authorities have now done with the TARP is logical. Taxpayers would clearly prefer that their money is used to acquire stock in on-going and functioning businesses rather than to buy complicated bundles of securities, with unknown values based as they are on delinquent or foreclosed mortgages. One factor prompting this change in approach has been the continued volatility of financial markets. As I have argued the crisis is centered in the US private housing market bubble of the past few years, even though it is now truly global in its scope. Symbolically, several US economists point out that this new approach of the TARP patterns that previously introduced in Britain to cope with the spreading effects of the financial crisis and credit crunch.
Issues to follow
Over the next few columns I shall explain the global dimensions of the financial crisis and credit crunch as well as US-led efforts at a globally coordinated response. After that I shall proceed to examine the economic dimensions of the present situation, focusing on their likely effects on Caricom.
Having identified the private housing market bubble in the US as the proximate source of the difficulties the world economy and financial system now face, it is clear that in my view there can be no lasting solution until a way is found to remove the toxic mortgages from the financial system. The problem here is essentially two-fold. One is that the value of outstanding toxic mortgages exceeds the value of the houses now that the private housing bubble has burst. Foreclosure, therefore, does not recover the value of the debt (mortgage) outstanding. The other problem is that these mortgages have been securitized, that is, sliced, diced, and bundled into black-boxes of indeterminate securities that are unrelated to their underlying mortgages. The true price of these traded securities is both unknown and unknowable. There are no theoretical or mathematical methods that can determine their price, as the assets now have innumerable slices or tranches of mortgages embedded in them.
In theory given the supply of housing in an economy which is determined in large measure by the profits housing investors expect to make and the availability of investment funds, the price of this housing depends in large measure also on the demand for housing. Broadly speaking the demand for private housing is a function of household income, the availability of mortgage funds and demographic factors (the rate of formation of households). As we saw during a housing bubble this foundation price becomes divorced from the price of the mortgages as both lenders (financial firms) and borrowers (households) deceive themselves into believing the rapid inflationary housing prices prevailing reflect true values. Several ingenious solutions have been proposed to resolve this dilemma. Personally I believe the only one that might work is if the US bankruptcy courts were legally allowed to redefine mortgage values on houses being foreclosed, based on the good faith, due diligence determination of repayment schedules borrowers can afford and lenders are willing to accept − given their likely losses when foreclosures take place in these courts. This, however, would be a slow and long-term process as millions of mortgages are at risk. Steps will be needed to speed up this process.

At the heart of the crisis response: the US Troubled Assets Relief Program

The United States is clearly at the epicentre of the global financial crisis and credit crunch. The scale of the havoc and damage already wreaked on the financial sector of the United States is one of the two clearest indicators of the awesome seriousness of what confronts the global economy today. The other indicator is the unprecedented magnitude and scope of the United States government’s response to this threatening situation. In previous columns I have discussed the first of these indicators. In this week’s column I start a discussion on the second indicator. 

Response
To begin with, the range of the US government’s res-ponse has been breathtaking. At its core is the Troubled Assets Relief Program, called TARP. This was introduced by Henry Paulson, Secretary to the US Treasury and approved by the US Congress and President. A sum of US$700 billion was allotted to this programme, to be issued in two equal tranches of US$350 billion. I shall discuss the provisions of the TARP in the next section after I give readers some brief indication of the other important steps taken by the US authorities.
A key complementary measure was to increase the size of the deposit insurance guarantee offered to bank depositors by the Federal Deposit Insurance Corporation. This was increased from US$100,000 to US$250,000 per customer. This action was done to quell fears among millions of depositors of likely bank failures. As indicated in earlier columns there were lists of scores of US banks circulating on the internet that could collapse. The risk was that these rumours could lead to be a run on banks if depositors sought to withdraw their deposits for safety.
Another action was to adopt a policy stance supporting the precept of financial firms considered as being too big to fail, known as TBTF. As we saw in previous columns this means that some financial institutions would cause so much economic and financial damage to the US economy that failure of these would under all circumstances be considered unacceptable. As I had pointed out previously, such a policy stance encourages firms to practise ‘moral hazard’ because it removes the primary disincentive firms face in the capitalist system − the failure to make profit would lead to their certain closure.
Action was also directed at the Stock Exchange where a temporary ban was placed on short selling. In other economies stock exchanges were temporarily closed (Russia). Although focused on rescuing troubled assets in financial depository institutions the TARP also included a commercial paper funding facility which supported in effect short-term loans to firms engaged in non-bank activities.
Troubled Assets

Rescue Plan
Originally, the primary goal of the TARP was expressed as the removal of “illegal assets that are weighing down the financial institutions and threatens the US economy.” The focus was on financial depository firms. To achieve this objective the TARP had to command sufficient funds, hence the large sum of US$700 million. The expectation was that the TARP would provide stability to the US financial system, remove the credit crunch, and prevent the US economy from going into depression.
As Secretary Paulson posited when introducing the programme to the US Congress, “the underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded.” This statement supports the claim I made last week that the housing bubble was the proximate cause of the financial crisis and credit crunch that erupted in the US. The official Treasury view was that the illiquid mortgage assets were toxic, poisoning financial markets and threatening a deepening recession or worse in the real economy.
In the original presentation of the TARP the US authorities placed most of the blame for what was happening on 1) predatory lenders in the sub-prime private housing market  2) the lax supervisory and regulatory agencies which allowed irregularities and illegalities to spread in these markets 3) the securitizers who repackaged and resold these toxic assets as good value ones and 4) irresponsible households and housing speculators who succumbed to their own greed when the price of housing was rising way beyond its normal rate.
The long-run trend in US house prices tends to pattern closely the US overall inflation rate. At the height of the private housing bubble the rate of increase in house prices was several multiples higher than the inflation rate. This and other issues raised in the previous paragraph will be considered in later columns in the series.
As the crisis has progressed several new policy dimensions have been added to the US government’s response, including as was mentioned last week, direct support for Freddie Mac and Fannie Mae, the two giant mortgage institutions in the US, and AIG,  the largest insurance  company in  the US. Two other policy actions will be considered in detail beginning with next week’s column. One of these is that the TARP programme has made a180° turn and is now to be focused on the purchase of preferred stock in the banks and their direct capitalization as a way of solving the problems posed by the illiquid assets parked in their portfolios.
The other policy stance is that the US government has worked very hard for a coordinated global response as the crisis spread at a rapid pace worldwide. The action culminated in the G20 Summit of leading financial authorities held last week in Washington DC (November 19-20, 2008).

At the epicentre of the crisis − a bursting bubble

In last week’s column I put forward the thesis that, the enormity of the global financial crisis and its associated credit cr-unch could be gauged from two indicators. Firstly from the carnage they have already wreaked on the United States’ financial system and secondly, the awesome scope of that government’s response. Without a doubt the United States is at the epicentre of the global meltdown. I have already considered the first of these indicators and in the process of doing this introduced two important financial precepts. One is that a credit crunch is different from a financial crisis. And, the other is that some financial firms are considered ‘too big to fail.’ 
The latter raises a number of systemic issues. One is that when firms take greater risks they expect increased profits for their risky behaviour. Such profits are privatized. When the risky behaviour fails and losses occur if the firm is considered ‘too big to fail,’ then taxpayers are expected to cover its losses. In such instances ‘losses are socialized.’ Such policies encourage firms to take risky behavior without risk to themselves. This is a clear instance of practising moral hazard.

Housing bubble
At the heart of the financial crisis in the United States is a private housing market bubble that has burst. And, because the United States is at the epicentre of the global crisis we can safely say that the proximate cause of the global meltdown is the bursting of the United States’ private housing market bubble. In order for readers to fully grasp the significance of this diagnosis that, at the heart of the crisis in the United States there is a housing bubble, which has burst I need to briefly indicate: what is a bubble?
This is a technical term used by economists to describe a situation in a market for any asset whose price or face value is rising rapidly and continues to do so with little or no regard to its underlying or ‘true’ value. This happens because purchasers of the asset and the financial firms that lend them the money to purchase the asset convince themselves that not only will the price of the asset continue to rise but that in fact it cannot fall!
In retrospect, after the bubble bursts it seems unbelievable that those involved in the market could not see the continuous deviation of the face value of an asset from its underlying or true value was unsustainable. However, it frequently happens.

What is a bubble?
Let us look at an example of an asset with which most readers would be familiar even if they do not possess the asset themselves. If the shares in a company or titles to property have continuous rapid rises in their prices with no regard to the income derived from these, a bubble is in the making. The income from the share is the dividend it would pay and from the property the rental value it could command. To purchase shares or property titles, purchasers would normally borrow money from financial firms using the asset as collateral. These firms would be willing to lend because in the environment of rising prices for the asset, using it for collateral against the loan used to purchase it would seem to guarantee repayment. If the borrower defaulted the asset could easily be sold to recoup the loan.
The classic definition of a bubble is “tr-ade in high volumes in prices that are considerably at variance from intrinsic values.” To be sure bubbles can be based on any asset. Indeed the asset describes the type of bubble. Thus a housing bubble is based on housing titles (mortgages). Financial bubbles are based on the general class of financial instruments. Stock exchange bubbles are based on the general class of stocks and shares. There have also been bubbles based on technical innovation, the so-called ‘dot-com’ bubble of the 1980s. There have also been other housing bubbles, for example Japan in the 1990s. All these bubbles have a common thread. That is, there is a speculative element as purchasers in the market are buying with the intention of selling at a profit.
Bubbles go through three distinct phases. First, there is a phase when the price of the asset is continuously rising. Purchasers of the asset borrow money from financial firms in order to enter the market. Lenders are quite willing to lend as loans do not look risky at all. They expect rising prices to continue. This is called ‘inflation based lending’ and is in fact a very risky policy to follow.
In the second phase of the bubble it becomes evident that incomes in the broader economy cannot sustain the current rate of inflation in the price of the asset. The face value of the asset begins to taper off. Purchasers are no longer willing to buy. Demand for the asset falls and so does its price. Lenders then become worried. They shift from inflation based lending to the standard and less risky ‘cash flow based lending.’ Loans dry up. And, as the asset price falls panic and anxiety hit the market for the asset.
In the third phase, the bubble bursts. The asset price collapses. Lenders now hold an asset that is now vastly devalued. Naturally they are unwilling to lend at any interest rate as the risk of default is great. In this situation several purchasers and lenders become, effectively bankrupt because they are left holding assets, which were bought at phony values. In the United States millions of households have found that the value of their outstanding mortgages is greater than the value of their houses. Many of these mortgages have been foreclosed and could not recover the sale of the outstanding value of the mortgage from the sale of the house.
This is indeed the heart of the financial crisis and housing crunch in the United States.
Next week I begin to outline the government’s response to this situation.

How is a credit crunch different from a financial crisis?

The enormity of the challenges posed by the present financial crisis and credit crunch is starkly revealed in its two most basic aspects, firstly, the enormous toll on the United States’ financial system and secondly, the unprecedented scope of the governmental responses, which have been provoked. 

The toll
At last count more than 60 financial institutions in the United States went insolvent or had to be rescued in the past six weeks. These include seventeen (17) commercial banks. And, among these casualties were massive banks like Washington Mutual and Wachovia. These two were taken over by JP Morgan Chase and Wells Fargo. The world’s largest insurance company, (the American Insurance Group, AIG) was also overwhelmed. So too were some of the country’s most prestigious investment houses like Bear Stearns and Lehman Bros.
During this period the scale of the sub-prime housing bubble became more and more evident. An estimated twenty-five (25) per cent of housing mortgages had mortgage value outstanding that was greater than the market value of the house. Not surprisingly, even the humongous mortgage institutions, Freddie Mac and Fannie Mae also became victims. The major US Stock Exchanges (Dow Jones Industrial Average, NASDAQ Composite, and the S&P 500) displayed exceptional volatility from hour to hour and day to day. Thus for the week ending October 11 the Dow Jones Industrial Average lost 18 per cent of its market capitalization value for the firms listed there.
On top of all these the slowdown in economic growth became more pronounced. In the third quarter of the year the value of US real GDP fell, reinforcing the widely held view that the country was firmly in the grip of a recession. Recent data on unemployment seem to support this outlook.
If one looked at the unemployment picture in the United States carefully one would have to consider not only the open unemployed, but those who are part-time workers who want to be full-time, as well as those that have given up on looking for work. These categories would cover what in Guyana are termed as the unemployed and under-employed.
Recent data published by the US Department of Labor show that while there are about 9.5 million workers unemployed in the United States, 6.1 million are involuntarily working part-time, in that they are looking for full-time jobs but cannot find them, and 1.6 million are no longer looking for work. This gives us a total of 17.2 million persons unemployed and under-employed, an equivalent of 11 per cent of the work force.

Amidst the carnage of collapsing financial institutions two financial precepts have emerged to the forefront of public discussion. One is the notion of a ‘credit crunch’ and the other is the status known as ‘too big to fail,’ which has been attributed to some financial institutions. Both of these are important technical terms, which I shall briefly elaborate on for the remainder of this column.

Credit crunch
Several readers have queried the title of my column last week, which listed the financial crisis and the credit crunch as separate phenomena. The reason for this is that technically, a credit crunch refers to a situation where there is an abrupt drastic contraction in bank loans or credit. In the present situation this has come about because banks in the United States are running scared over the quality of the assets being offered as collateral by potential borrowers. This phenomenon has become so widespread among banks to meet the standard of a massive credit crunch. Amongst those seeking to borrow are other banks, as well as firms and individuals. As a rule when credit or loans dry up, interest rates rise because of reduced supply. However, even at higher interest banks may still consider it too risky to lend.
Credit crunches can have other causes as we know from experiences in Guyana. Here the central bank and/or the government have in the past imposed sudden direct controls on commercial banks’ lending, restricting the amount and type of loans or credit they are permitted to make. They have also through the use of operations on the money supply and reserve holdings of banks induced credit crunches for broader economic purposes.
At present banks in the United States have become suspicious that other banks would fail because the quality of the assets they are holding is poor and risky. At the peak of the banking collapses indicated earlier, there was a list of about 120 banks in the United States, which investors were speculating would go insolvent or require drastic support from other institutions or the government if they were to survive. One thing stands out in the US situation: the credit crunch was preceded by persistent risky behaviour by banks, particularly in the way they were valuing collateral on which they were making loans or giving credit. This means that their balance sheets were stuffed with overvalued and unrealistically priced assets.
From the description above it is clear that a credit crunch is very different from other types of financial crisis. Thus for example a bank may have a ‘solvency’ crisis with all its assets properly valued because independent of this there is a run on the bank. The credit crunch in the United States is different and entirely due to overpriced or ‘toxic assets.’

Too big to fail
The other financial precept that has emerged into prominence is the notion that some financial institutions are considered as ‘too big to fail.’ In essence this means that the repercussions of their failure and the collateral damage to the broader financial edifice and eventually the real economy would be catastrophic. Government cannot possibly allow this to happen. The contradiction here is that the dynamic basis of the capitalist economy is survival of the fittest. That is, you make a profit or your firm goes under.
Next week I shall continue the discussion from this point by asking the question, what are the implications of this policy response.

The financial crisis and credit crunch

As promised last week, in this week’s Sunday Stabroek column I shall start a fairly extended discussion of the staggering financial crisis and worsening credit crunch facing the global economy, The epicentre of these is the United States.
Historically, the economic record of market capitalism shows clearly that, from its earliest beginnings, substantial credit, financial, and economic crises have periodically occurred as this mode of production became more and more deeply entrenched among nations and in regions across the entire international economy. In its most recent phase of maturity, commonly referred to as ‘globalization,’ the periodic credit, financial and economic crises have continued unabated. Indeed, if anything, these are now being transmitted across the global economy at an unprecedented pace, if not instantaneously. These have also been more and more tilted toward their credit and financial dimensions as compared with previous crises. In this basic sense therefore, we can argue that the origins of the present crisis lie in the intrinsic dynamics of market-based capitalist reproduction.

Given this general observation, it is nonetheless true that over time these crises have emerged in different forms and with various textures and manifestations. The present difficulties first became apparent in the third quarter of 2007. Regular readers of this column would recall that I drew attention to this at that time when referring to the “triple whammy” as it was termed, facing the United States and the global economy. These were rising food prices, oil prices and serious weaknesses in the sub-prime housing mortgage market of the US. The crisis of rising food prices is not as much a priority now as it was then. The price of a barrel of crude oil is now less than half what it was at that time. The weaknesses of the United States sub-prime housing mortgage market has, however, intensified to unbelievable proportions.

Volatility
Over the past two months (September-October) both the scope and scale of the credit and financial crises have unfolded with dizzying speed across the global economy! During that period the stock market has also shown exceptional volatility, losing and gaining trillions of dollars from one day to the next in the market capitalization of firms listed there, while trending downwards. Thus the Dow Jones Industrial Index has lost double digit percentage points since mid-October.
The speed of transmission of the present crises has added enormously to its complexity. As matters now stand it would require some serious effort on the part of readers of this column to fully grasp and comprehend the main outlines of the present difficulties, let alone to be able to discuss the various solutions on offer intelligently. In my recent columns on the EPA I had advanced the view that the complexity and technical nature of the EPA undermined well-intended efforts to make it the subject of broad based public democratic discussion. This observation, in my opinion, is truer for the present crisis.
Technical terms
As an indication of this proposition I have listed below 15 technical terms, which invariably recur in all serious commentaries on the present financial crisis and credit crunch that I have come across in the public media. These terms are:
1. Bubbles (whether they are financial, housing, stock
exchange or something else)
2.   Herding behaviour on the part of buyers and sellers
3.  “Mark-to-market” as the accounting basis for pricing
assets
4.  “Short- sellers” as a class of investors operating on stock
exchanges
5. Inside versus outside regulation of financial and credit
markets
6.  Financial innovations as risk diversification
7.  “Financial weapons of mass destruction”
8.  Credit-default-swaps (CDS)
9.  Structured finance and the securitization of assets
10.  Derivatives and options
11.  Transparency in contract reporting
12.  Golden parachutes
13.  Leveraging and de-leveraging of debt
14.  Fannie Mae and Freddie Mac
15.  Rating Agencies, which we do not yet have in Guyana
In the columns to follow I shall introduce all these terms and seek to explain their significance in context and in a manner that I hope is readily accessed by typical readers of this column. I wish to assure those not mindful of making this effort that it will be worth doing. As I shall endeavour to demonstrate, one of the most important contributory factors to the present financial crisis and credit crunch is that several of the key credit instruments on which the global financial system is grounded are opaque and not well understood by both buyers and sellers. When traded assets are opaque to buyers and sellers there are no ways to ensure that the prices of these assets reflect underlying market realities of demand and supply. As we shall see this is presently the main problem posed by the sub-prime housing mortgages.
Historically, all major financial crises and credit crunches associated with the workings of the capitalist economy have had, in different degrees, negative consequences on the real economy where goods and services are produced and distributed. These usually come in the form of unemployment, falling incomes, reduced private consumption, loss of consumer confidence in the economy, the wipe-out of pension earnings and so on. The most infamous example of this situation was the Great Depression of the 1930s. The principal concern being expressed about the present situation is not simply that it is already the worst since the Great Depression, but that it might, if not aborted, out-match the damaging proportions of the Great Depression.
The issues surrounding this will be treated in subsequent columns.
As we shall see although the negative effects of the crisis on the real economy are certain, their full dimensions cannot as yet be foretold. The jury is open as to whether the global economy is in for a protracted slowdown, recession or depression.