Wolfgang Munchau: Less Than 10% Through the Credit Crisis

Nothing like a sobering forecast to focus the mind on a Monday morning.

As readers may recall, I was deeply concerned early this year about excessive leverage, asset bubbles in many different markets, and complacency about risk. But it is one thing to know that things are likely to turn out badly, quite another to watch it happening.

The Financial Times’ Wolfgang Munchau, who similarly thought the credit market problems were severe, thinks we are only in the early stages of a prolonged contraction in both the financial markets and the real economy. And he thinks the dollar has nowhere to go but down.

From the Financial Times:

After the housing crisis and the credit crisis, now comes the US consumer confidence crisis. It is time to admit that the US economy is headed for a serious economic downturn – much bigger than suggested by the central bankers’ euphemism when they talk about “downside risks to growth”.

The world economy can now look forward to confronting four ugly and partly interrelated shocks at the same time: a US economy heading for the rocks, a rise in global inflation, a collapse in the dollar’s exchange rate and a credit market crisis.

I was a pessimist on the severity of the credit crisis from the outset, but events turned out even worse. I would now expect the time horizon of this financial crisis to be measured in years rather than in weeks or months. My own guess is that we are about 10 per cent through this, in terms of timing, less than 10 per cent in terms of costs to the financial sector, and much less in terms of the macroeconomic impact.

The reason why this crisis is so nasty has to do with the deep inter-linkages within the credit market, and between the credit market and the real economy.

Take, for example, a synthetic collateralised debt obligation, one of the most complicated financial instruments ever invented. It consists of a couple of credit default swaps, credit linked notes, total return swaps, all jointly connected in a wiring diagram that looks as though the structure was about to explode.

And, as many people with credit cards and housing debt in the US know, the linkages between the credit market and the real economy are only too real.

The credit crisis affects the world economy asymmetrically. The Anglosphere is harder hit than the rest of the world. The eurozone and Asia are much less dependent on consumer credit for economic growth. And, despite some spectacular early examples to the contrary, the eurozone banking system is holding up surprisingly well.

For example, Deutsche Bank said last week that there would be no further subprime-related write-offs. The French banks are also in relatively good shape. So one should expect the credit-related economic downturn to be much harder in the US than in the eurozone, where it probably follows on eventually, but with some delay.

One of the most important adjustment mechanisms is the dollar’s exchange rate. The euro is now closing in on $1.50. No matter whether you are looking at global monetary policy or at US growth forecasts, inflation or other technical factors, there is not much left to support the dollar.

Avinash Persaud, a well-known foreign-exchange expert, believes that the euro will go up to $1.70. I am not sure about the exact magnitude, but would certainly agree about the direction.

The only factor that could mitigate, or even prevent, an outright recession in the US is a very sharp further fall in the dollar.

What turns a spanner into this adjustment mechanism is the rise in global inflation. The big question is not whether the economic downturn or the rise in inflation currently poses the bigger threat. The really troubling question is whether both can happen at the same time.

Unless there is a steep fall in oil and food prices soon, there is a strong possibility of stagflation in the US next year. In such a situation, there are no easy policy choices. Monetary policy will probably not be able to support the economy in the way it did in past recessions.

Even a further decline in the dollar might not do the trick. When the recession finally strikes, corporate and private bankruptcies would almost certainly start to rise, which may well trigger the next crisis in the credit market.

How will this adjustment process end? There are several possibilities. The best outcome would be a symmetric slowdown in global economic growth – enough to take pressure off global inflation, but not big enough to do any damage – plus a gradual slide of the dollar, ideally against the currencies of countries with a high current-account surplus with the US.

If you are an optimist, stick with this scenario.

A less benign scenario would be an economic implosion in China, where annual inflation has gone up from around 2 per cent at the beginning of the year to more than 6 per cent in September and October. Unless China starts to revalue the renminbi, Chinese inflation may well go through the roof and do real damage. When that happens, the world could be a little less flat for a while.

Another possibility would be a devaluation-cum-inflation scenario in the US, with the euro at $2 and the pound at $3. Such an extreme devaluation in the dollar might well be accompanied by a permanent rise in US inflation. This could lead to extreme shifts of global trade and financial flows, and most policymakers would probably want to avoid this. I would not bet any hard currency on it.

There are undoubtedly many other adjustment scenarios, all difficult to pin down, given the prevailing uncertainties. The various adjustments will have to happen in any case, so it is probably better for them to happen now.

In a couple of years, it will be over. The bad news is that this is an environment in which it is easy for policymakers to make mistakes – and some probably will.