A year has passed since the initial cracks opened in the US debt markets and the term ‘subprime loans’ emerged into the wider public consciousness. Since then, a lot has happened – to put it very mildly – so let’s step back and try and see where we are, what we passed along the way, and where we’re heading.
Throughout the extraordinary turmoil of the last year, it has been easy to identify two main schools of analysis, comprising (as usual) the optimists and the pessimists. The former have consistently taken the view that the emerging crisis is limited in scope and that the worst is behind us, so that we should be looking for the light at the end of the tunnel. Super-optimists have periodically announced that they can discern that light. The pessimists, on the other hand, have consistently claimed that the latest development is only another stage in an ongoing deterioration, that things will get much worse and that any light discernable at the end of the tunnel can only be an onrushing express train, whose arrival will have disastrous consequences for anyone in its path.Regular readers will be well aware that this column has always been firmly in the pessimist camp – to which end it coined the clumsy mnemonic IKGW, to serve as both slogan and compass. It Keeps Getting Worse has been a highly effective guideline since the crisis blew wide open in July-August last year, and it remains relevant and valid today. Unless and until there is hard evidence that ‘it’ has stopped getting worse, the rule that “the trend is your friend” applies, meaning that the dynamic is still negative. It is therefore essential to define ‘it’ — and let’s start with what ‘it’ isn’t, namely the direction of prices in specific markets. The degree and extent of rises and falls in various asset classes, including equities, government bonds, non-government and corporate bonds, currencies, commodities and all the rest, are not the substance of the problem, merely symptoms. They indicate whether and where there are problems, and how severe these are; even then, they should not be used on a short-term basis, let alone day-to-day, but only in a larger perspective.
What ‘it’ really relates to is the state of the financial system as a whole and of the US and global economy. For each of these, a host of indicators is available and must be used. It is unrealistic to expect that they will all be synchronised, so that they move in the same direction, at the same pace. Therefore they have to be considered collectively, while the weight attached to each one will perforce be a matter of subjective opinion, allowing for differing conclusions to be reached.
However, the bottom line is too clear-cut to be impacted by any minor differences. On the contrary, over the past year more and more former optimists have folded and joined the pessimist camp, because the overall state of the financial system is so unequivocally dire and because the state of the US and global economy is so plainly deteriorating. Nevertheless, hard-core optimists – as well as neutral or pessimist observers subject to occasional spasms of doubt or bouts of self-delusion – maintain the mantra that ‘the worst is behind us and recovery is imminent’.
There are two main and inter-locking reasons why the general public – ably represented by readers of this column – should be and remain pessimistic. Both are factual: one is that the health of national and regional economies virtually everywhere, and of their financial systems, is deteriorating. Indeed, the most chilling aspect of the last few months is that even the pessimists have been shocked by the speed, breadth and intensity of the deterioration taking place. The rate of pace of decline is accelerating – the delta is steepening, it’s IKGW squared!
Secondly, it is impossible to relate seriosuly to optimistic pronouncements, because the optimists have destroyed their own credibility. Two years ago – yes, two – they said that the decline in US house prices then just starting would be a brief and shallow correction. One year ago, they said that subprime debt was a small problem, limited to one part of the overall American debt market. Nine months ago, they said that it was an American problem, with no relevance to the rest of the world. Six months ago, they said that the debt problem was a financial issue that wouldn’t spread to the real economy months ago. Three months ago, they said that the third-quarter provisions made by institutions like Citi and Merrill had resolved their exposure to ‘subprime’. Now they are saying that Bush and Bernanke have resolved the crisis with interest rate cuts and a ‘fiscal package’. Get real, people. IKGW rules, OK!