Return of the financial crisis

Last week has been a very exciting time for anyone with any money in the stock markets. The KLCI plunged to lows not seen since the depths of the financial crisis of 2008, then strongly rebounded over the next couple of days. Anyone who had bought SP Setia’s warrants early in the week practically saw their money doubled following the takeover announcement by PNB. This week looks set to be a continuation of the rollercoaster ride though the overall trend remains bearish. I personally expect the markets to edge down for at least the next few months, though there will certainly be plenty of technical rebounds along the way.

The pundits are calling this the return of the financial crisis. For those in the US, it feels more like the crisis merely took a breather and is now back with a vengeance. For middle-class Americans in particular, it has already been a lost decade echoing what happened to Japan. With no end in sight for the European debt crisis and with the Americans set for a rematch between the Republicans and the Democrats over the raising of the debt limit in November, things look certain to grow worse before they can get any better.

What galls me the most however is the fact that this rerun of the crisis is almost entirely due to political factors rather than fundamental economics. Yes, America’s budget deficit looks bad and their debt is growing at an unsustainable pace. But that is really a long-term problem and in the short and medium term, the US debt is perfectly fine. US bond yields are laughably low and there is no prospect of them going up any time soon. With inflation low as well, the US government still has plenty of scope to use fiscal policy to stimulate the economy.

Over the long term, the US debt problem can be attributed almost entirely to healthcare costs. They need to do a fundamental rethink of how much right their citizens have to healthcare and how to distribute those costs. They need to either accept that there is a certain point beyond which each extra month of life that they can give a dying patient isn’t worth the money or to accept that taxes need to raised significantly to pay for the healthcare costs of the elderly. Everything else is a sideshow that buys a bit of extra time but will never resolve the problem until they confront this choice head on.

As for Europe, I agree with The Economist in that the EU needs to man up and draw a line between insolvent and illiquid countries. Greece is insolvent. Everyone knows this no matter how fervently EU authorities deny it. Portugal may or may not be insolvent depending on the next few months. Every other country in the EU currently under pressure in the bond markets is merely illiquid. Insolvent countries need to have their loans restructured, essentially imposing losses on creditors. This would destabilize the EU banking system. So be it. Let bank shareholders eat the losses until their equity is gone, then use public money to recapitalize the banks and rebuild the financial system as necessary. Basically, the EU should bail out banks as institutions, but not their shareholders and not insolvent countries.

In the meantime, illiquid countries need to be given unlimited backing by the rest of the EU. This will increase borrowing costs for safe countries like Germany and the Netherlands, but their public needs to accept this as the cost needed to save the EU.

Naturally, none of this will happen because the political costs are too great. In the US, the Tea Party has successfully sold to the general public the idea that deficits must be cut immediately and savagely without any care of how much damage this would cause to the economy and no politician will dare to say otherwise. Similarly, no politician in the US will dare to tell American citizens that sometimes a tiny incremental improvement in healthcare isn’t worth the massive costs it would incur.

In the EU, singling out Greece would be too humiliating to contemplate and the more often Sarkozy and Merkel declare their infinite support for Greece, the harder it will be to do the right thing no matter how much more worse Greece gets. And of course, any northern politician who dares to tell his voters that they need to pay a bit more tax to help out the southern countries will be cleaned out at the polls in election season, even if this means everyone will be better off in the long run.

This means that both the US and the EU will continue to limp on, kicking the can down the road as far as they are able. Sometimes it sucks to be a democracy.

2 thoughts on “Return of the financial crisis”

  1. Despite the troubles of the US economy, US dollars is still considered a safe haven in times of turmoil. So investors around the world are exiting emerging markets and buying big into US bonds and treasuries. It’s normal. Check out the rise of the Swiss franc against other major currencies as it is also considered a safe haven currency.

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