Panics: Die of Exhaustion Or From Policy Overdose?

``Word to the wise - don't accept advice or analysis about this crisis from anyone who failed to anticipate it in the first place! The people warning about Depression now are the same reckless jackasses who told investors that stocks were cheap and “resilient” at the highs.”- John P. Hussman, Ph.D. Four Magic Words: "We Are Providing Capital"

Let me offer a non-sequitur argument: Because we could be destined for doom, we might as well bet on hope.

In other words, with so much of the prevailing gloom in the atmosphere this could, by in itself, possibly signify an end to the panic.

As Morgan Stanley’s Stephen Roach eloquently articulated in the International Herald Tribune (hightlight mine), ``The most important thing about financial panics is that they are all temporary. They either die of exhaustion or are overwhelmed by the heavy artillery of government policies.”

True enough, as we have always pointed out, doom or boom or market extremes have simply been accounted psychological phases of the market cycles.

Nevertheless, Mr. Roach uses the Professor Charles Kindleberger’s “revulsion stage” as a paragon for the possible panic endgame.

Professor Charles Kindleberger in Manias Panics, and Crashes A History of Financial Crisis identifies the phase as [p.15] ``Revulsion and discredit may go so far as to lead to panic (or as the Germans put it, Torschlusspanik, “door-shut-panic”) with people overcrowding to get through the door before it slams shut. The panic feeds on itself, as did speculation, until one or more of the three things happen: (1) prices fall so low that people are tempted to move back into less liquid assets: (2) trade is cut off by setting limits on price declines, shutting down exchanges or otherwise closing trading, or (3) a lender of last resort succeeds in convincing the market that money will be made available in sufficient volume to meet demand for cash.” (highlight mine)

While low prices and lender of last resort could likely be more pragmatic solutions, it is doubtful if the cutting of trades or closing exchanges will succeed in limiting the panic phase. As the recent examples of Indonesia and Russia manifested, temporary suspensions of bourse activities have not deterred the onslaught of a rampaging bear.

It would be more suitable for the markets to discover the price clearing levels required to set a floor than to applying stop gap solutions that only delays the imminent or worsens the scenario. Price controls rarely work especially over the long term and could lead to extreme volatility.

Nonetheless, with the successive coordinated barrage of heavy systemic stimulus by global central banks, possibly attempting to err on the side of a policy overkill, we might as well hope that 1) these efforts could somehow jumpstart parts of the global markets and or economies that have not been tainted by the US credit bubble dynamics or 2) that market levels could be low enough to attract distressed asset buyers which could provide the necessary support to the present levels.

While it likely true that the credit system in the US and parts of Europe have been severely impaired and will unlikely restore the Ponzi dynamics to its previous levels that has driven the massive buildup of such bubble, the most the US can afford is probably to buy enough time for the world economies to recover and pick up on its slack and hope that they can the recovery would be strong enough to lift the US out of the rut.

Divergences of Policy Approaches: Asia’s Market Oriented Response

One thing that has yet kept the world out of pangs of the 1930s global depression is that global economies have remained opened and that actions of policymakers have been constructively collaborative instead of protectionist.

Put differently, the world has been using most of its combined resources to deal with such a systemic problem. While such grand collaborative efforts may lead to the risks of huge inflation in the future, the scale of cooperation should likely diminish the menace of “deflationary meltdown”.

So while the US and Europe have closed ranks and concertedly used governments to assume the multifarious roles of “lenders of last resort”, “market makers of last resort”, “guarantors of last resort” or “investors of last resort” to shield its financial system from a downright collapse, Asia’s approach has been mostly “market-oriented”.

Some of the recent developments:

1) Taiwan removed foreign ownership restrictions or opened its doors to the global marketplace (Businessweek) encouraging overseas companies to list, aside from attracting potential foreign investors (particularly China’s resident investors) to participate in Taiwan’s financial markets.

2) Taiwan slashed estate and gift taxes from 50% to 10% (Taipei Times)

3) The Indian response: From the Economist ``On October 6th the Securities and Exchange Board of India removed its year-old restrictions on participatory notes (offshore derivative instruments that allow unregistered foreign investors to invest in Indian stockmarkets). The next day, external commercial borrowing rules were liberalised to include the mining, exploration and refining sectors in the definition of infrastructure. That raised the cap on overseas borrowing for companies in these sectors from US$50m to US$500m—although there may be little international money to borrow.” (highlight mine)

4) To cushion the effects of a global growth slowdown, China’s leaders are presently deliberating to allow its rural farmers to sell or trade state owned land rights and possibly also extending the tenure of land rights ownership from 30 to 70 years.

According to the New York Times, ``The new policy, which is being discussed this weekend by Communist Party leaders and could be announced within days, would be the biggest economic reform in many years and would mark another significant departure from the system of collective ownership and state control that China built after the 1949 revolution….Chinese leaders are alarmed by the prospect of a deep recession in leading export markets at a time when their own economy, after a long streak of double-digit growth, is slowing. Officials are eager to stoke new consumer activity at home, and one potentially enormous but barely tapped source of demand is the peasant population, which has been largely excluded from the raging growth in cities.”

So what could be the potential impact for such a major reforms to China’s rural population? See figure 4.Figure 4: Matthews Asia: China’s Rural and Urban Incomes

According to Matthews Asia, ``This reform is timely as a growing wealth disparity between China’s rich and poor is becoming a concern. China’s rural economy, despite representing over half of China’s population, has lagged behind urban economic development. The agriculture sector currently accounts for less than 12% of the nation’s GDP compared to 25% two decades ago. The top 10% of wealthy individuals command more than 40% of total private assets in the country. The impact of this reform is likely to benefit both the agricultural sector and rural areas by increasing agricultural investment and rural consumption. Enhanced rural standards of living should also help improve farm productivity and yields, important aspects for China to continue its self-sufficiency in grain production.” (highlight mine)

In other words, we shouldn’t underestimate the reforms undertaken by Asian governments out to achieve productivity advantages by tapping into market oriented policies while their western counterparts are presently burdened with restoring credit flows and in the future paying for the cost of such rescue missions.

Inflation As The Next Crisis?

So while the risks are real that the US banking sector could collapse and ripple to the world as global depression, the lessons from Professor Kindleberger shows that panics either exhaust itself to death or will likely get overwhelmed by an overdose of inflationary policies.

Basically all we have to watch for in the interim are the actions in the credit markets. So far we have seen some marginal signs of improvement, but not material enough to declare an outright recovery, see figure 5

Figure 5: Bloomberg: Overnight Libor (left), and TED spread (right)

Yes, markets almost always tend to overshoot, especially when driven to the extreme ends by psychology spasms, but ultimately credit flows are likely to determine the transitional shifts.

If credit markets do recover, market concerns will likely move from threats of a systemic meltdown brought about by “institutional or silent bank runs” to one of the economic impact emanating from the recent crisis.

Besides, the policymakers are likely to keep up with such aggressive pressures to reinflate the system and possibly engage the present crisis with a zero bound interest rate policy which basically adds more firepower to its various arsenals to combat deflation.

It isn’t that we agree to such today’s policy actions but it is what they have been doing and what they will probably do more under present operating conditions. This means that if they succeed in reinflating the system the next crisis would likely be oil at $200!

Figure 7: iTulip: Inflation Is The Menace

According to Eric Janzen of iTulip ``Since the international gold standard was abrogated by the US in 1971, ushering in the second era of floating exchange rates in 100 years – the last one ended badly as well – no deflation has occurred. Japan's experience with "deflation" would not show up on this graph because in no year since 1990 has deflation in Japan exceeded 2%.

“We continue to expect that the actions of central banks to halt deflation will, as usual, in the long run work too well.”

So hang on tight as the next few weeks will possibly determine if our doomsday emerges (and I thought they said that the scientific experiment of the Large Hardon Collider risks a true to life Armageddon) or if the impact from the inflationary overdrive of the collective powers of global central banks materializes.