A Drag, But Not a Crisis

Op-ed in Welt am Sonntag

September 27, 2007

Four months ago in this space, I wrote that "there will be no large negative impact on growth from the current real estate bust in the United States, though some individual homeowners and communities are suffering." In the time since then, we have seen a "lock-up" in credit markets, notably the interbank and asset-backed commercial paper markets, collapsing values and markets for some mortgage-backed securities, bank runs in the United Kingdom and bank failures in Germany, and the Federal Reserve deciding to cut interest rates. It would seem that things have gone rather badly for American financial markets.

Yet, I am still not very worried about overall US economic growth. Yes, there are significant cutbacks in residential construction in the United States and some declines in consumer confidence. But as I said back in May, it is the transmission of the real estate shock to the broader real economy, not the shock itself, which matters. And so far no news has come out to suggest that the initial shock will be transmitted into large and persistent negative effects.

There are three pieces to recent financial disruptions (I do not think we should call it a "crisis"). First there was the interruption in the rolling over of credits between large commercial banks and in the commercial paper they issued to some borrowers. This had the potential to be the most serious, because this was at the core of the global economic system, and it was reflected in increased spreads between interbank interest rates and same duration government bond rates. This kind of liquidity problem is precisely what central banks were created to deal with and what their tools are best suited to fix. Thus, both the Fed and the European Central Bank cut their discount (overnight) rates and broadened the assets they would accept for collateral, and the problems lessened. As time passes and lenders discover that their regular counterparties have few hidden problems, this will go away.

Second, there were the losses of highly leveraged investors, including but not only the infamous hedge funds, on various "off balance sheet" activities with a range of acronyms (SIVs, MBSs, et al). If one looks at the notional value of these derivatives, that is contracts whose value is based on other underlying assets and securities, the vulnerabilities seem very scary. Yet, the growth of these contracts was only notional-just as with foreign exchange markets whose daily turnover now exceeds international trade by several orders of magnitude, the amount of these contracts traded has completely disengaged from developments in the real economy.

There is legitimate concern for core money-center banks which will be liable for some losses on these securities, even though they were supposedly off balance sheet, if the losses were big enough. That is what those banks' capital reserves are for, however, to cushion such losses. And the amount of capital and earnings available to these global banks at present is far larger than the losses that have accumulated or than they had during the last US banking crisis of the early 1990s. Some very rich investors will have also lost money on risky bets, which is hardly a public policy concern. Recent events will not erode the capital of the US banking system significantly, so the only cut backs in lending will be from the repricing of risk, which is a welcome development.

The third piece of the recent financial disturbance is the direct effect on the US housing market. Unlike the interbank lock-up or the potential for losses from off balance sheet derivatives, there would seem to be no need to assess the likely size of these effects transmitted to the real economy, since they are already part of the real economy. That is a misleading approach. Various sectors of advanced economies, and various asset classes, surge ahead and fall behind all the time. Residential real estate, while larger than many other sectors and asset classes, still is just getting its turn in the down cycle, as technology and heavy manufacturing in the United States recently did before it.

The question is whether the movements of a particular even large sector have persistent or knock-on effects on the economy as a whole. We can certainly mark down the US growth forecast for the last few months of 2007 a little bit due to some additional decline in household consumption and construction, but that is not something worthy of ongoing concern. From an ethical and political perspective, the US system has again displayed its tendencies to have the poorer people suffer too much of the burden of economic adjustment when shocks come, and to provide too little regulation protecting consumers (in this case mortgage borrowers). But 2 to 3 million mortgage borrowers finding difficulty with payments in an economy of 140-plus million households, and only a small fraction of those actually falling into foreclosure, while real estate markets remain liquid, just is not that large an effect in the aggregate.

The US economy is far from invulnerable, especially over the long term given our failures in education and our declining productivity growth trend, but its financial system remains one of its key strengths that makes up for some of its other failings. This noncrisis will put a small drag on the US economy into spring of 2008, but not more than that, especially with the Federal Reserve ready to act. When this financial shock turns into a nonevent, it will only serve to demonstrate that securitization and financial innovation did what it was supposed to do: disperse the risk and protect bank capital such that the real economic impact of financial fluctuations is limited.

And if the German economy suffers more than trivially from the last few weeks' financial events in the United States, it will be because this process of liberalization has not gone far enough in Germany's three-pillar banking system-and thus financial shocks get amplified in the real economy by undercapitalized banks. I am worried that there are more IKBs and Sachsen LBs waiting to happen.