Liquidity - The Great Unwinding
Cancer - a malignant tumor of potentially unlimited spreading growth affecting different parts of an otherwise healthy organism. This was the story of the beginning of the end for unfettered free-market capitalism à la Milton Freedman.
Nearly four years ago I remember having spirited conversations with a good friend of mine from my MBA program. He strongly believed the current real estate boom that Central London was experiencing was unsustainable, and at some point in the near future would have to equilibrate. I strongly disagreed with him, arguing that London, being a global city of high desirability, would never experience a real estate price melt down, especially in the highly sought after zones one and two of the city.
The two of us were never able to fully agree on our central argument. Indeed even today he remains highly skeptical of the ability of Central London to escape a price melt down, while I still contend there is enough global cash liquidity to protect the value of land near the River Thames. Yet that aside, my friend and I were able to see eye to eye on one central theme, that being the inevitable “Great Unwinding” of global liquidity that was so overdue back in 2005.
Today, facing a market in shambles and a global crisis so beyond borders, one can only ponder how so many people in such high positions failed to act on something so obvious to two MBA graduates in 2005. How could it be that billionaire CEO’s and political and financial leaders failed to anticipate this “Great Unwinding”? Shocking it is that men paid millions of dollars ignored Isaac Newton and acted as if “what goes up must just keep going up.”
Even through the surge in oil prices, leading economists and treasury managers believed that somehow that American middle class would miraculously be able to continue consuming outsourced Chinese rubbish made from Brazilian, African, and Canadian raw materials, shipped and packaged in Saudi oil, and financed by foreign banks, even while they had less in the bank, and their dollar was worth less and less with each passing day. They feigned belief in a never ending unsustainable rise in home prices to finance middle class consumption through surging non-core inflation.
The argument of economists was that as long as oil price volatility did not seep into core inflation, then consumer prices indexes would remain stable, allowing Mr. Joe Plumber to continue to buy his Chinese made washing machine at much the same price it would have been if he had of bought it one year earlier - this despite a sagging US dollar. Yet the argument had one major flaw. It failed to understand that despite raw materials not being factored into core inflation, they do affect price volatility, and consequently consumption very quickly. This was no more apparent that in the sudden consumer rush to switch from American made SUV’s to Japanese and European fuel-efficient vehicles, when gas prices began rising to unheard of levels this past summer.
Outside of the US, the rise in commodity prices was already having it affect. Emerging market labourers were rioting for higher wages to cope with higher costs, food prices were increasing due to higher shipping costs and higher demand for food products as sources of biofuels, and manufactured products were increasing in price due to increased labour costs and commodity costs. Needless to say, the convergence of all of these factors, along with the important issue of a devalued US dollar relative to other major currencies, meant that by early summer the United States was blindly facing an impending wave of price increases.
This tidal wave was of significant concern to the United States Federal Reserve, since its primary mandate was to protect the US economy from inflation by utilizing interest rate moderating techniques to stymie price increases. Faced with the impending inflation wave, the Reserve began to preemptively raise interest rates, hoping to reduce the force of the demand curve on consumption and consequently control price increases.
The Federal Reserve rate increases worked exactly as intended, forcing the middle class to reduce spending, and moderating the strength of the demand curve for raw materials and consumer goods. Yet it also had a perverse effect.
The United States, and indeed most of the planet had been experiencing a real estate bubble created out of a global economy that had been awash in liquidity from years of low interest rates under Alan Greenspan’s tenure as chairman of the Federal Reserve Bank.
This liquidity had allowed trillions of dollars to be printed and invested in commercial and residential real estate projects in Bulgaria, Atlanta, Cape Town, Spain, and London. Lots of easy money meant to loose lending and spending habits, as bank managers were rewarded for “selling” cheap loans to even the most suspect borrowers. It was commonplace around the world to see people with debt servicing ratios that were out of reason as they borrowed money to flip or hold condos in places they had never even been to, relying on capital gains to pay bills.
While alarming, this situation was encouraged by deregulated lending markets that encouraged brokers to lend money out in the form of mortgages and credit cards. This debt was then package and sold on the market between lending institutions, making it very difficult to determine who actually owned the original assets backing the loans.
Fast forward to the summer of 2008, and the sagging US dollar, offshore inflation due to labour, commodity, and oil price surges; and Fed rate increases, and one ends up with a toxic mix that in a few short weeks wipes out trillions of liquid cash off the books as mortgage after mortgage defaults under mounting monthly bills and rising interest rates. In just a few short weeks millions Americans - mostly those who should never have been homeowners - are in default and have lost their homes. Like a cancer, this in turn quickly spreads through the body of the financial system, taking down banks that had bought repackaged toxic mortgages and were no stuck with valueless repossessed homes no one could afford to buy. It was not very long before these banks began to collapse, starving from a lack of liquidity.
The oil price crisis, followed by the sagging US dollar crisis, had quickly imploded from the mortgage crisis to a banking and housing crisis. By the autumn of 2008, the world was no longer awash in cash, the US government, after a decade of deregulation under George W. Bush, was forced to swing wildly in the opposite direction and nationalize the banking sector to stop the cancer from spreading further through the financial system.
As we sit on the cusp of uncertainty, one can only hope that the incoming US administration will grasp the importance of a having a healthy element of government influence in the free market. Allowing a market to behave unto its own has given us the result we have today.
It will be essential that the incoming government in Washington stabilize markets, regulate the financial sector, and reduce government spending. Everything needs to be streamlined. It is also essential, once this crisis is overcome, that the US Government gradually reduce its holdings in the financial sector, since as bad as zero regulation is, excessive regulation inhibits the ability of a free market to drive the creativity, ingenuity, and designs of a modern democratic society.