Economic Consequences of the Paulson Plan

In the US:

The consumer is quite broke. Unemployment is rising. Firms have no access to credit. And now the government is quite broke too. The cost of cleaning up the banking system will fall on the government first. A budget deficit would imply austerity and a severe limitation to government fiscal spend as well as possibly higher taxes down the road.

The Fed will have to cut rates or face deep recession. Normally this is highly inflationary but given that the BRICs are slowing down as well, inflation is likely not to be a problem.

The USD will come under pressure improving terms of trade and providing some relief to the economy in the form of export growth. This will be limited by the synchronized slow down in Europe and Asia.

The recovery will take multiple years depending on the approach taken. If the scale of the bailout is big enough and the time frame is short and decisive enough, this could take a further 2 years or so to work through.

Equity markets should begin to price this in earlier but no further than 1 year in advance. Credit markets may react more quickly.

This is the good case scenario.

Credit and the economy

The scale of the credit crisis is huge and current wisdom, and it is pretty convincing, is that there will be no way out for at least a couple of years more. On the other hand, US economic growth remains robust even as unemployment rises in certain sectors and retail sales falter.

We already see that economic growth is not going to be driven by the consumer, by investment or by the government, primarily because all 3 groups have stressed cash flows and balance sheets. The one leg upon which any faster than expected recovery or softer than expected landing rests, is trade.

How does the current credit crisis fit into this scenario? Spreads are generally wide. That makes it hard for consumers to borrow for consumption and hard for firms to borrow for investment. Libor has been very volatile indicative of the damaged integrity of the banking system. Fannie Mae and Freddie Mac are likely insolvent, and in any case are levered to extreme levels. With a combined market cap of less than 6 billion USD, 36 billion in prefs and 19 billion in sub debt, while backing over 5 trillion USD of mortgage debt, the insolvency of the GSE’s is not improbable. That said, the fact that the banking industry is a large holder of prefs and that the banks themselves are large issuers of prefs, mean that any bailout will likely have to be a wholesale bailout across the prefs as well as common equity. The costs to the taxpayer, already 25 billion and rising. On top of the primary action, the CDS market, side bets if you like, total over 6 trillion USD. Aside from the scale of the financial impact, roughly half of 6 trillion since there are two parties to each swap, so 3 trillion, X whatever default rates X the residual value, there is the issue of locating the risk since CDS are over the counter, non exchange traded instruments. This could potentially create a domino effect as CDS triggers result in counterparty defaults.

All this pretty much impacts the domestic economy, but what about trade? Trade decisions are based on relative demand and supply and comparative advantage. Trade finance while Libor based are relatively short term, fully secured against cargo and unlikely to see the extent of spread widening in corporate debt markets. While the BRICs are slowing as well, the nature of their demand is likely to evolve so that infrastructure investment begins to take centrestage. Even Socialist and Communists can be Keynesian. The high tech and capital goods and industrial supplies economies of the US and Germany are likely to profit from this, as long as the terms of trade are favorable. The Japanese solution throughout the 1990s was in part to depress prices, debase the JPY and export its way out of trouble. In the meantime, the Fed may hope that while they keep interest rates low, long term US government bond yields will rise creating a steeper yield curve and the opportunity for banks to reflate via another (risky) carry trade.

Time is what the US economy needs. For the weaker USD to take hold, for the trade balance to adjust, for tax receipts to stabilize government coffers, for export and (later) tax cuts to sow the seeds of growth in another evolution of the US economy.

Will they be given that time?

Europe

The Eurozone recorded its first quarter of negative growth since 2003. Annual growth had peaked in 2006 at 3.3% and is currently 1.5% and slowing. The distribution of growth was not uniform with Spain and Italy clearly slipping towards recession. France and Germany continued to report stable albeit slowing growth. The UK also was slipping towards recession.

Domestic consumption saw a similar picture. Spain saw particular weakness, as did Italy, France and the UK. Germany registered robust growth. In retail sales, Spain has fallen off a cliff. Italy and France were also very weak. UK retail sales appeared to be holding steady while in Germany, retail sales accelerated.

In Exports, Germany, the UK and Italy registered steady growth. France saw some weakening. German trade balance has been in surplus and steady since 2000. In France the trade balance has been volatile, in Italy it has been steadily deteriorating while the UK has recorded a persistent deficit.

Economic confidence peaked in Summer 2007 and has since slumped across Europe. Business Confidence has been very weak in the UK and in Spain has nose dived. In Germany and France it declines but remains positive.

Consumer confidence tracked business confidence, collapsing in all except Germany where it is just beginning to turn down.

Employment numbers had been positive for the last 7 years averaging 7.2% unemployment in the EU and 5.2% in the UK. The current economic slowdown has not impacted employment yet but signs that it is beginning to are showing, particularly in Spain.

The one bright spot in Europe is Germany where a significant external sector fuelled by demand for capital goods from emerging economies continues to support the economy, this despite a strong EUR and disadvantageous terms of trade.

Already the German Ifo business climate and expectations lead indicators have fallen sharply in the last month. Construction holds steady but has never really been a source of strength, manufacturing, wholesale and retail indicators were all substantially weaker. Industrial production has fallen sharply from 5% to 1%.

The currency will be an important factor as the recessionary economies of the US and Europe vie for the emerging market dollar.

Twenty seconds into the future…

Inflation Comment

The US and Europe cannot fight inflation by raising interest rates because their domestic economies are not pushing against full employment. The source of inflation is from the emerging markets. The US and Europe need China and India to raise interest rates and fight inflation. If they get what they need, that means interest rates in emerging economies rising faster than USD and EUR rates. In terms of term structure, USD and EUR yield curves will only flatten if BRL, CNY and INR curves flatten first.

The more likely scenario is that China and India are facing serious inflation. China will act to slow inflation, India is slightly caught between a rapidly cooling economy and together, aggregate demand will slow. The implications for the rest of the world will be an easing off in energy prices, then food prices, albeit to a lesser extent, and thus lower risk of inflation. The US and Europe will find themselves less motivated to combat inflation.

The price of stable prices will be slowing emerging economies and thus demand for US and European exports. Taking the US as an example, consumption is likely to be weak from poorer consumer sentiment, rising unemployment and weaker income, investment is likely to be weak from scarcity of credit, poorer business expectations, weaker corporate profits, the government is broke, any spending might be inflationary. Trade is almost the last hope for any earlier or stronger than expected recovery. That requires export demand from countries other than those in similar financial health or lack thereof: the developing world. If that part of the world is slowing down, it doesn’t leave much hope for a quick recovery.

What could change that is investment in infrastructure in parts of the developing world where inflationary pressures can be addressed by ad hoc and specific measures, i.e. where market prices do not apply wholesale to the economy and there is sufficient central planning, and where balance sheets corporate or sovereign still have the firepower.