Control is key in economic fightback

Oct 22 2008 by Bill Gleeson, Liverpool Daily Post

RARELY have the pros- pects for the world economy appeared so uncertain, after what has felt like a hurricane- driven restructuring of the US financial system in recent weeks.

While there is general agreement on the need for the US and other western economies to reduce debt, there are wide differences of opinion over how rapidly this should occur and whether the immediate threats to confidence in the financial system will degenerate into a collapse.

The problems have been rooted in unsound lending by parts of the banking sector, creating losses that eroded the thin layer of capital available to absorb losses. This led to a freezing up of nor-mal credit channels and recurrent speculation over the fate of a series of banks. The atmosphere at times approached feverish panic after the bankruptcy of Lehman Brothers, leading to fears for other parts of the banking sector, in a self-feeding series of collapses. This is why banks became unwilling to lend to each other and why investors, stung by losses in bank shares, were unwilling to stump up the additional capital needed.

The resulting collapse of confidence threatened to choke off the supply of credit to the world's main economies, which could have had consequences similar to those in the 1930s – falling output, rising unemployment and widespread financial distress. This dire prospect led to a series of hastily improvised but eventually coordinated measures by world governments and central banks, to reopen the supply of credit to the bank sector, remove some of the damaged assets from their balance sheets and directly inject new capital into the banks to strengthen their capacity to absorb losses and to renew lend-ing to consumers and businesses.

Despite relief that radical actions had been taken to ensure the stability of the financial system, stock markets have remained volatile. In part, this is because the financial turmoil has increased the risk of a sharp recession. There are also signs that tighter credit and losses from recent market events are prompting forced selling from hedge funds and other overstretched investors.

Seemingly ignored in the mood of deepening gloom, the building blocks of a more controlled way of restructuring the banks have fallen into place. Substantial amounts of new capital have been raised, substantially under-written by governments, while Central banks are providing mas-sive quantities of liquidity to smooth the adjustment while the interbank lending markets re-cover confidence. Although this has been controversial, the alternative of economic depres-sion would have been more expen-sive in terms of increasing public debt (quite apart from the human cost). Further, managers of the banks viewed as having made errors have been sent packing and there seems a reasonable prospect that the government money invested in bank share capital will make money.

Although investors are suspending judgment over the success of these measures, this is normal in times of crisis, when investor confidence is frayed. Pessimism itself may not be a sufficient reason to buy, but it is not necessarily a contra-indicator. History indicates that buying low after market falls is a better strategy than buying into the optimism at market peaks. We believe that an unduly negative view of the future is priced into financial markets (especially corporate bonds and equities) but a period of lower volatility is necessary to allow sentiment to regroup. Investors are then more likely to pick up the cheese on offer without looking for a mousetrap underneath.

ANDREW BELL, Head of Research, Rensburg Sheppards Investment Management