A Year in Crisis - Who Pays?

We have an odd situation whereby the financial markets are having a record year of profits after governments have rescued the financial institutions by massive guarantees and zero-interest-rate policies.

The US dollar has depreciated and carry trade is creating bubbly markets in the emerging markets. By the end of November, the Dow Jones was up nearly 20 per cent, the China A share more than 80 per cent, the Euro 100 up 30 per cent, gold prices up 60 per cent, oil and metal prices over 45 per cent.

In the real sector, growth in industrial production and GDP remain negative in the advanced countries, while unemployment is over 10 per cent in the US, just under 10 per cent in the EU, but Chinese growth has climbed back above 8 per cent, and emerging markets are all beginning to show signs of recovery. Hence, some economists are calling the crisis over. Others say that we have wasted a good crisis, because the very success in stemming panic in financial markets has reduced the political will to reform markets and economies structurally round the world.

The party in Wall Street is not over, because no one has taken away the punch bowl. Less than one year after they were rescued by the government, some Wall Street bankers are going to get even higher bonuses than in the peak year of 2007. Others think that with zero-interest-rate policies, more bubbly has been added to the punch.

This once-in-a-century financial crisis will be debated for years to come, either because it was solved quickly or decisively, or because the majority have been fooled by the short and quick recovery which disguised a more serious real-sector depression that may be much more prolonged than expected.

In hindsight, we had two excesses. In the advanced countries, we have excess financial engineering, built largely on leverage. Excess financial engineering and leverage was due to excess consumption, which ultimately led to the global warming problem. In 2008, when the price of oil reached $147 per barrel, central bankers were in a dilemma over whether the oil price would lead to global inflation. Less than three months later, the world crashed into deflation.

In the emerging markets, we have excess real engineering capacity, because much of our production was designed for exports to the advanced markets. As the de-leveraging proceeds, the emerging markets will have to cut back on the excess capacity and therefore the real-sector restructuring is only beginning. If real-sector restructuring leads to huge unemployment, then the political mood will get ugly and protectionism will return. That was essentially what happened in the 1930s.

Thanks to the zero-interest-rate policies, the world is one big carry trade and emerging markets are very bubbly. Investors are now once again caught between greed and fear. Greed drives many to join the momentum play but fear rises as prices go higher and higher. Dubai gave a reality check that property prices do not go upward forever and reminded others that bankers still have a lot of commercial property deals in their books. 

Financial crisis occurs because the aftermath of a bubble in asset prices leaves large losses in the net wealth of the private sector.

In the Japanese crisis of 1990-1997, the estimated losses were as much as 2.7 times GDP because the bubble in the stock market and the real estate market was huge. Japan paid for the bubble of the 1990s with very slow growth and a large fiscal debt equivalent to 200 per cent of GDP. All this is sustainable with almost zero interest rates, so in reality, the Japanese saver paid for much of the losses. The tragedy with very low yields on stocks, real estate, bonds and zero deposit rates is that the super saver has very little income to retire on.

Under the current zero-interest-rate policies globally, the whole world will pay for the losses incurred by Wall Street. Who benefits from zero interest rates? The real sector is still borrowing at pretty high rates, because the whole purpose of low interest rates is to subsidise the banking system by giving them a high spread, the difference between lending rates and deposit rates.

US 30-year fixed-rate mortgages are still at 5 per cent per annum - pretty high real interest rates especially if you face the prospect of unemployment. If the fiscal deficit is now over 10 per cent of GDP, the Fed's balance sheet has trebled and OECD money supply growth at its highest in real terms since 2002, the risk of future inflation is rearing its head. This accounts for the fact that gold, commodity and house prices are back up as savers try to find a suitable hedge against inflation and the depreciation of the US dollar.

In other words, the cost of the current crisis will be paid for globally by future inflation, taxation, unemployment and lost consumption. Because the US dollar is the dominant reserve currency, those who hold dollar assets will share part of that burden of depreciation.

It is not surprising that the world is schizophrenic about both deflation and inflation. Economists like Paul Krugman and Nouriel Roubini are in the camp of deflation, whereas investors like Soros and Warren Buffett are signalling that they are worried about inflation. Of course, for those with lots of debt, inflation would be welcome because that inflates away the real value of the debt. For those savers whose returns are not higher than the inflation rate, they will share the burden of the inflation tax.

What is quite clear is that most of the world is going to pay for this crisis. So, please send a Christmas card to those Wall Street bankers who are enjoying record bonuses to remind them that all of us are paying for their party.

Note: Andrew Sheng, former chairman of Hong Kong Monetary Authority, is the author of the book "From Asian to Global Financial Crisis" and a regular writer for Asia News Network.