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Friday, September 19, 2008

"A quick primer on this week’s events"

From the ANZ Bank's Amy Auster and Amber Rabinow:

The unusual developments in the global financial markets have rattled investors over the past week. Below is a quick summary of what has happened and why, and what it might mean.

Consolidation in the US financial system. The bankruptcy of Lehman Brothers Holdings and the mergers of Merrill Lynch – Bank of America and HBOS – Lloyds were significant events. The moves were forced by the continued downward spiral of share prices, as investors feared that these financial institutions would no longer be able to raise sufficient capital to finance the loans and other assets that were on their balance sheets. Only one of the three institutions that ceased to exist this week was a commercial bank that holds deposits on behalf of households. The other two were investment banks that have to raise their debt funding from the capital markets. As financial conditions have become tighter and tighter over the past year, it has become more and more difficult for this business model to be maintained. Concern over the investment bank model is what has caused the share prices of the two remaining Wall Street investment bank firms, Goldman Sachs and Morgan Stanley, to remain under pressure this week. In Australia, Macquarie Bank’s equity value was also under pressure, but rose quickly on Friday...

US government support for institutions that are core to the US or global financial system. Over the past few weeks the US government has taken the extraordinary step of taking control over three financial institutions: the government-sponsored mortgage giants Fannie Mae and Freddie Mac, and the global insurer American International Group. This was accomplished through the issuance of new, preferred stock that had the effect of making the US government the majority shareholder in these firms, and guaranteeing the payment of the debt that had been issued by these institutions.

Why did the US government take this step? The simple answer is that allowing these institutions to go bankrupt could have conceivably caused a shutdown of the global payments system, thrown the US housing market into chaos and caused enduring harm to the US economy. The steps taken by the US government this week are not the ultimate solutions to the problems facing these institutions, but they do buy some time so as to avoid hasty, destructive actions.

While commentators have called the move a “bailout”, this is not entirely correct. The holdings of existing shareholders in Fannie, Freddie and AIG have been completely diluted, and their shareholdings at present are worth very little. Bondholders can be assured that they will continue to receive interest payments, but they are not being bought out of their positions.

Most importantly, all three institutions will be forced to significantly change their businesses, primarily by selling down the assets – such as mortgages or other securities – that are currently on their balance sheets. In the case of Fannie and Freddie, the reduction will be about US$1.2 tr in the coming years. In the case of AIG, sales could amount to US$712 bn and entire parts of a company that had a balance sheet of US$1.04 tr as of June 2008.

Finally, governments around the world have undertaken further policy measures in an aim to shore up financial stability. The US Federal Reserve, European Central Bank, Bank of England, Bank of Japan, Bank of Canada and Swiss Central Bank – and the Reserve Bank of Australia – have all acted to inject funds into the financial markets to promote liquidity in the system and discourage banks from hoarding their cash. Such action helps to reduce the stresses in the short-term interbank market, where just a small rise in funding costs causes significant rises in longer-term borrowing costs for banks and their customers.

In addition to central bank action, the US Treasury and other US authorities have taken steps to address market turmoil. The US Treasury this week announced an increase in its funding program of US$100 bn (0.8% of US GDP) to provide the Federal Reserve with more capacity on its balance sheet to fund liquidity injections and help reduce the burden of unwanted assets on the credit markets. Separately, the Securities and Exchange Commission has adopted newregulations aimed at reducing short-selling in the equity market, which some observers blame for having caused such a sharp sell off in financial stocks over the past month.

The week ended with statements by US Treasury Secretary Paulson and others confirming plans are underway to establish a (government-funded) agency that will buy bad debt from the financial sector. This would be an institution similar to the Resolution Trust Corporation (RTC) that was established in the wake of the US Savings and Loans crisis of the 1980s. At that time, the total cost to the US taxpayer of this institution was US$123bn, or 2.1% of 1990 GDP. The establishment of such a vehicle is positive in the sense that it is the first attempt to systematically address the debt overhang now plaguing the US financial system.

What does this all mean for the future For now, the uncertainty in the financial markets is likely to persist. We may see more rumours of mergers and/or failures by other institutions, in the United States and elsewhere. The reason is that the balance sheets of these large, financial institutions are connected and interwoven with each other in ways through a complex chain of lending and borrowing. When large institutions start to fail, other institutions react by pulling back their loans to those institutions, as well as others. This causes a chain reaction of a progressive reduction in the availability of funds, and as the reduction deepens other institutions face difficulty obtaining the financing they need. A crisis of confidence ensues, and that is what central banks are working assiduously to avert by pumping cash into the global payments system.

Some observers question whether pumping cash into the payments system is inflationary. Under normal circumstances, the answer might be yes. However, the deflation in asset prices (equity, bonds, and property) that we have seen in the United States puts deflationary pressures on the economy. Economists call it a negative feedback loop, which looks like this: Falling asset prices cause households to feel they are losing wealth. The consumers in these households cut their expenditure, and consumption falls. Producers see falling demand, and cut back on production – and possibly lay off workers. Falling employment causes consumption to fall even more, and the cycle worsens. Such an environment is a recipe for disinflation, or falling inflation. What modern central banks target is price stability – a stable mix of growth and inflation. The steps being undertaken by central banks this week are a bid to re-establish financial market stability, and thereby ensure a desirable mix for growth and inflation is attained. Given the continued uncertainty, we can expect to see more of these sorts of measures in the weeks ahead.