Understanding the Global Economic Crises: Factors, Impacts, and Solutions, Lecture notes of Managerial Economics

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THE CRISIS

Factors Underlying The Crisis

Spending Beyond One’s Means:

 (^) US and many western countries have been spending more than they earn for many decades  (^) central government (internal budget deficits)  (^) country as a whole (exports/imports)  (^) individual households

Factors Underlying The Crisis (cont’d)

Shift From West to East:  (^) China, India, and other Asian countries have begun an industrialization process comparable for its impact on the world to the industrial revolution led by Britain in the 19th century:  (^) The Chinese have been following a “mercantile” policy of selling goods to all comers based on low prices and low manufacturing costs  (^) To maintain these low prices, they have deliberately kept the value of RMB down against the USD  (^) For the American (and other western) consumer, this has meant being able to purchase all sorts of goods at prices previously unimaginable even 10 years ago, but it reinforces the tendency to spend more than one earns

Factors Underlying The Crisis (cont’d)

Sub-prime Crisis – Immediate Cause:

 (^) The sub prime crisis (the immediate cause) is a reflection of the overspending practice of the USA rather than the fundamental cause of the current economic problems  (^) The price of housing went up so much that it was a bubble waiting to burst  (^) The entire CDO mechanism multiplied the impact of the housing bubble burst  (^) Resulted in bank failures and toxic assets

Government’s Approach to Right the Crisis (cont’d)

 (^) The US and other Western economies are being kept afloat by excessive government spending  (^) Massively increased government debt  (^) No obvious way out of this impasse:  (^) Withdraw government stimulus and the economy contracts, risking deflation  (^) Continue government stimulus and the debt becomes ever larger, risking stagflation  (^) If medium and long term interest rates rise, the recovery is choked  (^) All points to an L shaped recession / recovery

Then a new crisis came along…

 Initially this paper was to have

dealt with the aftermath of the sub-

prime crisis

 (^) Then Greece upset the apple cart  (^) Fears raised by Greece spread to other southern Euro Zone countries

 The underlying problem is a single

central bank, but 16 different

“Treasuries,” many of which have been

lapse in their budgeting

 The one-interest-rates-fits-all led

to housing bubbles

Then a new crisis came along…

(cont’d)

 (^) If there is no single “Treasury,” then at least the 16 must collaborate and harmonize  (^) The newly created European Financial Stability Fund (EFSF) will have bond issuing authority (a new “Supra”)  (^) Whether voluntary or under compulsion, a degree of centralization within the Euro Zone is inevitable  (^) Will it provide the kernel of a fiscal harmonisation authority? My own view is that the founders of the euro are so committed that a solution will be found to prevent break-up.

Exit From Both Crises

 (^) The lower value of the euro enhances European competitiveness  (^) already seen in expanding German exports  (^) Even tourism & property should improve in the “south”  (^) Just as in the USA, the most that can be hoped for is a long, slow recovery -- another “L”  (^) A fundamental shift in the economic paradigm has occurred leaving the “West” with higher levels of umemployment for years to come

Impact on Bond Markets (con’t)

 (^) Low credit bonds are a sort of corporate equivalent to southern government bonds  (^) The lower end of investment grade corporates offer opportunity, i.e. A, BBB  (^) Selected emerging markets offer a satisfactory risk return profile e.g. Brazil, Turkey, South Africa, Russia  (^) The commodity countries can be attractive for both the yield and the currency e.g. AUD, NZD, CAD

Impact on Bond Markets (con’t)

 (^) In terms of average maturity, it had seemed likely that yield curves would steepen  (^) Maturities as short as three (3) years were recommended  (^) However, the arrival of the second crisis (Euro Zone), and fear of a double dip recession in the USA suggests moderate lengthening  (^) For institutions from five to seven years  (^) For retail investors three to five years While institutional investors can change maturities at little costs, retail investors have to think in terms of holding to maturity.

THE LONGER TERM

 (^) Many governments have long-term liabilities left off their debt data  (^) They would be declared bankrupt if subject to private-sector accounting  (^) Situation is unsustainable  (^) « financial oppression » rather than bond default is in store  (^) Retirees (pensions and medical care) in a battle with bond holders  (^) Inflation is easiest way for a government to reduce its indebtedness.

ROY’S PERSONAL CONCLUSION  Current deflationary environment cannot endure if recovery takes hold (and if it does not…..)  (^) Risk of inflation from excess money supply  (^) Risk of yield curve steepening  (^) A small proportion of investments should be in linkers What happens when QE is reversed?