September 2008 | By Ignacio de la Torre, Professor of Finance and Academic Director of IE’s Master in Finance.
Except for the odd diehard, nobody is denying that we are facing a credit crisis that is affecting the mainstream economy. The question is: Where do we go from here?
In the city of Boston in the 1920s, an Italian immigrant, Roberto Ponzi, convinced hundreds of people that investing in Spanish and Italian stamps with guaranteed profitability levels was a better option than buying traditional products, such as bonds and shares, whose high prices had rendered them less profitable. Of course, the promised levels of profitability came from the revenue generated by those who were the last to buy the stamps, which is why the English term for this type of con trick is “Ponzi scheme”, which made Roberto eternally famous.
Does this sound familiar?
A scenario of economic expansion with controlled inflation, as took place in the 1920s or, more recently, since 2004, eventually leads to a heavy increase in the money supply. This leads to increases in the real prices of assets (fixed assets, stock exchanges, bonds), dampening their implicit profitability. Investors look for alternative products that can give them greater profitability, causing successive “bubbles” in said assets as they attract investments (in 2006, the JP Morgan index for emerging bonds offered profit levels that were only 1.3% higher than the North American bond). Paradoxically, as pointed out by the economist Hyman Minski in the 1970s, trust in the central bank´s success can involve a disproportionate expansion of credit, which, in turn, brings about greater falls in default (since the refinancing of the debt is easy in this kind of environment), giving rise to a vicious circle. The circle is blown to pieces when a significant event (such as the non-payment of the subprime mortgages) leads the market to reconsider its appetite for risk and this reconsideration brings about a fall in credit, which is quickly transferred to the real economy with the threat of a possible recession (which is where we are today).
In this context, which investment trends are we starting to see? One: while banks continue to have liquidity problems, they will offer very attractive interest rates for term deposits. As the problems in the financial sector are not expected to end soon, the deposits will continue to be a favourite among investors, with the consequent departure of assets from investment funds. Two: even though the deceleration of the West is bad news for emerging countries, their general fiscal health and that of their current account balances is enviable. These factors will enable emerging countries to continue growing at rates which, although lower, will be more than healthy.
Therefore, the investment flow into emerging countries (direct or portfolio investments) will be maintained. Three: as a result of the above, the economic health of emerging countries will continue to imply the annual inclusion in the middle classes of around 70-80 million people. These middle classes will demand oil and other raw materials at a high rate and with low price sensitivity.
Accordingly, albeit with the customary ups and downs, raw material prices will remain high for a long time and continue to attract investment flows. Four: as a further consequence of points two and three, the accumulation of reserves in emerging countries will continue to appear as acquisitions by sovereign funds of significant share packages in western flagship companies, which will increase political tension among governments. Five: inflation will take its time to fall and it will continue to generate significant social tension in the West and emerging countries.
The growing polarisation of income between the poor and the rich in developed and emerging countries, together with inflationist tension (the burden of petrol and food in a poor person´s shopping basket is much greater than that of a rich person´s; therefore, inflation is slightly higher for a poor person than for a rich person), will give rise to political reactions of unknown consequences. For their part, countries with currencies linked to the dollar (such as China or Saudi Arabia) will be forced to reappraise their currencies albeit in detriment to part of their exports in order to limit the unsustainable inflationist trend in their countries. Six: as important European economies enter a state of recession or near-recession and the ECB is forced to reduce interest rates, the value of the dollar in comparison with the Euro is expected to increase.
It is worrying to read an account of the 1929 recession owing to the similarities it has with the situation today. Fortunately, we have central bankers that are very familiar with the huge errors that were made during that recession. It remains to see whether or not the political powers will be capable of preventing the recession from getting worse. Place your bets.