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Professor Roger Bowden

Don’t Panic!

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It’s all a bit unreal, the credit crunch, but if there’s a message coming out of it, it’s engraved on the cover of the Hitchhiker’s Guide to the Universe: Don’t Panic.

True enough, the world financial system does seem to be in a terrible mess. Any financial system depends crucially upon the confidence of these who trade and work in it, and just at the moment there’s all the unreality and impending doom you might feel when looking into the maw of the Ravenous Bugblatter Beast of Traal. But hang in there, for things are not all that bad, especially so if you happen to be living in Godzone.

It all seemed a good idea at the time. Home mortgages would be bundled up into tranches of different credit status; ‘securitised’, in the jargon. The originating banks would then spin them off into special investment vehicles (SIV’s), or flog them off to investment funds and the like, all apparently priced to reflect the different degrees of risk. Insurance companies and other banks could and did write ‘credit default swaps’, under which they derived a fee for assuming the risk that the underlying mortgages would default. It might strike you as a bit surprising that banks would ever do such a thing, but remember, they were supposed to know all about mortgage risk and how to price it.

It all came unstuck, for several reasons. The first was that the US economy started to turn down, and the penny dropped as to whether a large chunk of those mortgages would ever be repaid. The second problem was that the SIV’s that bought the mortgages had to fund them somehow and they did that by issuing short dated commercial paper. It was this market that collapsed in a heap when doubts arose about the quality of the asset backing.

So the SIV’s had a terminal liquidity problem. This was the missing factor that all the quants had not taken into account. Bad mistake: they couldn’t price risk after all. It didn’t trouble the financial vogons who got millions in bonuses at the time. But it has returned to haunt us all. Taxpayers throughout the world have to carry the can, amounting now to trillions of dollars.

So much for the history. I think the financial system will recover all right and pretty soon, possibly through the medium of the very people who did all the short selling that aggravated the mess. Hedge funds will see that many of the troubled assets are in fact perfectly OK and badly underpriced at that. Government that have bailed out their banks may even end up making a few bucks when they sell off all the preference shares they are acquiring as part of the deal. They can then afford to retire all the government debt they have had to issue. Right now there is an appetite for government debt because of the flight to quality. When the governments come to buy it all back, interest rates will be a bit higher, and it will cost them less to retire the debt.

So it’s not all gloom and doom for the beleaguered governments. There will likely be longer term costs for society, notably in the huge prudential and risk management bureaucracy that governments will insist be put into place in the finance industry. But that’s another story.

Where does it leave us here in NZ, and what sort of signals should it be sending to our policymakers? Our banks are in good shape; not too many worries there. The Reserve Bank has gone out of its way to support them by accepting all sorts of funny security like mortgages and commercial paper.

We will certainly feel the cold economic winds that are starting to blow all round the world. No escaping that. But people always need to eat, and babies always need their bottle, though the San Lu timing is doubly unfortunate for us as well as Fonterra. Primary commodities are good things to be in right now.

Moreover, the Reserve Bank will sooner or later have to slash the official cash rate, even if they didn’t do it today. When that happens, the NZ dollar will drop even further than it did last night. That is very good for all our exporters, and in the fullness of time it will flow though to the rest of us. Oil prices have already dropped to saner levels, even if a weaker currency will stop us enjoying the full fruits thereof, as will the energy trading system – a tax in effect, if not in name.

In the meantime, there’s that election. Treasury came out with its Prefu, which is designed as sort of condom against the adverse effects of political arousal. It’s a useful document in itself because it shows just how things might have blown out in the last 5 months. It is pessimistic about the tax take from a declining economy; about public spending on things like education; about the Waitangi settlements; and other adverse variations. As a result, they expect government debt to rise to something like 26% relative to GDP by 2012.

My own take is that the Prefu was little too pessimistic as to timing and as to amount. Small variations can have very large effects on the bottom line, so that if interest rates did drop the blow out in government debt would not be as large as they have projected. A drop in the NZ dollar would raise tax revenues from export incomes, and so on. The counterargument is that the Prefu data preceded the full horror of the credit crunch, so maybe the Treasury might be right after all.

At any rate, it’s had the desired effect on the parties. The Nats have scaled back their tax cuts, basically to just a cosmetic trim on Labour’s. They have promised a more rigorous cost benefit analysis on our burgeoning bureaucracy, something I sounded off about in The Economic State of the Nation. Hopefully, no more spin doctors, stakeholder engagement managers, or overseas trade representatives, though don’t hold your breath. They will cut the corporate tax credit for R D and hack about a bit with other programmes like the Fast Forward research initiative of the Labour government (I share the scepticism on that one). They will cut back on Kiwisaver. After all, you could argue for one or the other: the NZ Super Fund or Kiwisaver – why have both? Indeed if things look bad, just remember that a lot is still getting squirreled away for a rainy day in the Cullen Fund.

But as to all of this, I do not think that the government, of whatever ilk, should lose their nerve. If there is to be a slow down, then we need countercyclical action, not to make things worse by cutting back willy nilly. I think the Nats are on the right track with infrastructure spending, which primes the short term pump and helps with long term productivity. Moreover, it’s perfectly justifiable to finance it by issuing long term debt. Even if the Prefu was right and we end up with 26% against GDP, the comparable prudential figure for the EU is actually 60% or for the Poms 40%. But there we are: after the Muldoon years, public debt is a dirty word here in NZ, and such fears die hard.

Just for once, I think we are the lucky country in all this, along with the inevitable Aussies. I hope I’m right. I also hope that the squillions being poured into rescue packages by the US , UK and European governments will work, and work soon. We should be grateful to them, the more so as we are not their taxpayers. Free riding is a wonderful thing, you might say, but after all, who made the mess in the first place?