Saturday, March 22, 2008

Saturday Forum: What if the money runs out?

The heads of the US Federal Reserve and the Australian Reserve Bank come across as cautious and unexcitable. Except for when they are driven by their deepest, most primal fear.

Then they work so fast and act so brutally that the banks they regulate won’t see them coming.

A private bank can be outwardly healthy, rich and respected during the week. Its revered chairman and chief executive can be hauled in to the Reserve’s headquarters over the weekend and ordered to immolate and surrender to an immediate takeover for a mere fraction of what it’s former worth.

I’m talking about the Australia’s Reserve Bank and the then Bank of Adelaide back in 1979...

Not to be confused with the unrelated entity The Adelaide Bank Limited, which itself was subject to rumors about its solvency last year and was later taken over, the Bank of Adelaide was in 1979 the seventh biggest bank in the Australia.

It was having trouble with a subsidiary that had got too deeply into real estate finance. But it had just reported a healthy profit and its establishment chairman Sir Arthur Rymill had arranged a rescue package for the subsidiary.

In his book Two Centuries of Panic, the doyen of Australian financial journalists Trevor Sykes describes what happened next.

Harry Knight the Governor of the Reserve Bank rang Rymill out of the blue and abruptly directed him to fly to Sydney and meet him at the Reserve Bank’s HQ “on the unbankerlike day of Saturday May 5”.

Rymill and his General Manager were let in through the back door and went up to Knight’s office.

Knight asked to see Rymill alone.

As Rymill later recounted it:

“The Governor said that he had a decision tree – he talks in metaphors – and he said that at the top of that tree – the tree apparently being what he saw as the possibilities – at the top of that tree was a merger of the bank with another larger Australian trading bank and at the bottom of that three, which he regarded as the last option he wished to exercise, was entry into and taking possession of the bank. The Governor told me: ‘I propose to enter if I deem it necessary, whether it is lawful or not.’”

It was, in Sykes’ words “not so much a shotgun wedding as a shotgun funeral”. Had the Bank of Adelaide been given more than just a few days in which to choose who took it over its shareholders might have got a high price. Instead the ANZ bought them out for a song.

Reserve Bank staff have since made it clear that this wasn’t accidental. They were determined to send two messages about what would happen if ever an Australian bank got into trouble; its deposits would be honoured, and its shareholders would be punished to the maximum extent possible.

That’s how it worked for Bear Stearns in the New York headquarters of the US Federal Reserve over the weekend.

The Wall Street Journal spoke to an insider at the negotiations that led to the instant demise of America’s fifth largest investment bank. “We thought they had given us 28 days,” he said. “Then they gave us 24 hours”.

Bear Sterns, with a history almost as long as Australia’s Bank of Adelaide was told to sell out to JP Morgan for a pittance.

Its shares had been worth around US$100 each at the start of this year. They were worth US$30 going into last weekend, and by the end of the weekend and the Fed’s ultimatum, just US$2 each - the price at which JP Morgan agreed to buy them.

Its employees, who own around a third of the shares, will lose billions.

In theory it would be possible for the shareholders to try to block the deal (as some of them tried to do at the Bank of Adelaide), but if they succeeded the share price could fall to zero if the Fed withdrew support or assumed command (as our Reserve Bank apparently threatened to do back in 1979).

On one measure the Fed has cut the Bear Stearns price to less than zero. The purchase price is US$240 million. But he building that houses the bank’s corporate headquarters (which goes to JP Morgan whether or not Bear Stearns shareholders approve the deal) is said to be worth five times that much.

The frequently-heard suggestions this week that the Fed “bailed out Wall Street” couldn’t be further from the truth.

Like our own Reserve Bank in the late 1970s the Fed tried to inflict maximum pain on the bank’s shareholders, while at the same time not losing track of its overriding goal.

That goal is not, as is sometimes claimed, to avoid a recession. Recessions come and go (just as a downturn in the South Australian economy would have come and gone had the Bank of Adelaide failed).

The goal is to keep the financial system functioning.

Most of the time most of us don’t think about money. We think about the things it can buy or the things that we can sell to get it.

That’s especially so when we think about trade. China needs our resources, the argument goes. Australia has the resources, and so will be able to dig them up and sell to China for as long as China wants them.

It’s a way of thinking suggests that Australia has little to fear from the collapse of a US financial institution. Most of the goods China makes are now sold to its own citizens, and so it will continue to need our iron ore and gas whatever happens in the US.

But it ignores the role of money.

There’s a display in the foyer of the Melbourne University’s Department of Economics that makes the role of money clear.

It’s a billiard table sized model of the Australian economy made out of perspex pipes. If interest rates go up more water flows from one pipe into another, and so on.

The most important point unintentionally illustrated by the pipes is not where they go but that they need water to operate.

Without access to money, or “liquidity” as it’s called, the model won’t work.

Australian miners may well be keen to sell more resources to China, and China might well want them, but if they are unable to borrow money to develop new mines, they won’t be able to.

The deepest fear of central banks right around the world is that people with money will simply refuse to lend it.
Lenders and borrowers will be so traumatised by what’s happened to the financial system that they’ll refuse to take part.

If that happens even the deepest cut in official interest rates won’t make any difference. Our Reserve Bank, the US Federal Reserve and central banks worldwide will have lost control.

The Nobel Prize winning economist Paul Samuelson warned of the possibility late last year.

He said it used to be enough for a central bank to “lean against the wind.”

They could cut interest rates if they needed to stimulate the economy or hike them if they needed to wind inflation back.

But if people with money became so worried about the financial system that they refused to part with it, the system would dry up.

“The safest bond interest rates are indeed low,” Samuelson observed. “But financial panic engendered by the burst bubble of unsound US and foreign mortgage lending means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.”

A collapse of Bear Stearns or an institution like it might dry up the flow completely.

Anyone doubting that this is possible need only look north to Japan.

An avalanche of Japanese bank collapses in the early 1990s destroyed the trust of would-be lenders and borrowers in the Japan’s financial system.

No matter how low the central bank pushed the indicator lending rate – it got down to 0.25 per cent – borrowers simply wouldn’t borrow and lenders simply wouldn’t lend.

The Japanese literally stashed their money under floor boards.

Disturbingly, last Wednesday’s 0.75 per cent cut in the US indicator lending rate is bringing it closer to the low reached in Japan. At 2.25 per cent it is approaching the level below which there is nothing to cut.

Japan’s government was at one point semi-seriously advised to hire a helicopter, fly it low over Tokyo and keep throwing out bundles of 10,000 yen notes until people grabbed them and began to spend.

Instead it pumped ever-increasing amounts of money into the economy by building ever newer and bigger roads, power stations and so on.

It didn’t work. The economy stayed stalled, in a “liquidity trap” for a decade.

If the same thing happened worldwide, Australian economic growth would collapse as well.

The ANZ’s chief economist, Saul Eslake, says something like that is beginning to happen.

He says the international debt securities market - on which home lenders such as Aussie and Rams have relied - has “effectively closed”.

The big Australian banks are able to fill the gap for the moment, but they too have only limited access to foreign finance, and will soon reach the limit of their ability to lend their own money.

As perhaps as much as $200 billion of international borrowings by our non-bank financial institutions fall due and are not renewed our banks will find themselves increasingly unable to step into the breach.

As Eslake puts it, “Clearly, the banking system cannot both meet ‘normal’ growth in demand for credit and absorb maturing securitized debt that can no longer be rolled over in the capital markets. Hence credit rationing, at least for business borrowers, is becoming a reality.”

Credit rationing would mean that some borrowers would find it hard to access money at any price. In Eslake’s words, part of our financial system would have “seized up”.

Eslake has wound back his forecasts for economic growth in anticipation of the capital shortage and says there is a “non-trial risk that the slowdown could begin earlier and be deeper” than he has forecast.

It’s the main reason why Eslake is no longer predicting any further interest rate hikes in Australia. He says the impending gumming-up of the worldwide financial system should slow things down here without the need for further work by the Reserve Bank.

Indeed the Bank might find that it needs to cut interest rates and do all it can to encourage our banks to lend to the maximum of their abilities if the worldwide capital strike deepens.

A collapse of any of the US investment banks would be enough to do it.

There is already evidence that what has happened so far is stalling worldwide growth.

Europe’s Bureau for Economic Policy Analysis reported on Friday that growth in global trade has stood still since the start of this year and is threatening to turn down.

Without ready access to money, or ‘liquidity’ as the economists call it, trade can’t take place even where it should.

Any politician wondering whether or not that frightens the Governor of Australia’s Reserve Bank can ask him.

Glenn Stevens will subject himself to his semi-annual grilling from the House of Representatives economics committee on Friday.

It is telling that the last time he appeared before the committee, in August, the US financial crisis had only begun.

He said at the time that the problems were generally “embarrassing rather than fatal” for the institutions concerned.

It was “extremely unlikely that the sub-prime mortgage exposures could significantly damage the core banking system in any significant country”.

He is likely to be less relaxed this week.

His counterparts in the United States worked through last weekend with scarcely any sleep and committed US$30 billion of public money to make sure the Bear Stearns takeover worked.

They’re worried indeed.

2 comments:

Nicholas Gruen said...

Unless it's moved recently, the machine you speak of is not in the foyer of the building, but on one of the lower floors of the building.

Anonymous said...

You used to say, Peter, that money in the bank earned more than say, any other. I realise that the situation changed, given the share market, the low interest rates.

But now, surely, returning to cash is the go, in light of your years ago assessment.

The situation is surely as it was?

Higher interest rates. Share market on the downturn, my super is in there.

I am worried. In two months, I can get the super out. I will be 60.

I cannot wait. Should I wait?

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