Sunday, October 05, 2008

My bro's comments on the financial crisis

My brother wrote an article injecting some reality into the discussion about the banking crisis on Spiegel Online. The german version can be seen here. I'll share a short summary of his arguments here (and he'll complain about my distortions later ;).

Short version: The article describes why the situation is less dire than many pundits claim, and explains logical fallacies in commonly-heard arguments.

In the following, here's a summary of his arguments, in the form of "Myth --> Reality"
  1. The US government is taking on a total of 7000bn in liabilities -- about 5500bn by agreeing to step in for Fannie Mae / Freddie Mac, and about 700bn in papers bought by doing the bailout. This equates to roughly half of US GDP, and since the US is already in debt by about 65% of GDP, this would push the total indebtedness of the US to be clearly past 100% of GDP. As a result, serious doubts would have to be cast on the US governments ability to repay debts and service interest on debt.
    Reality: Most of the 5500bn are backed by "proper" mortgages with decent quality. It is unclear whether the US gov will lose money on the Fannie Mae / Freddie Mac deal at all. Even the 700bn in "toxic assets" the US is willing to buy have some underlying value. Realistic expectations at the total loss for the US government in this deal runs in the area of 500bn, which would be less than 3% of GDP -- and therefore not a significant source of problems.
  2. The liquidity that central banks are injecting into the markets should lead to hyperinflation. Reality: The measures to help liquidity in the markets do not increase the money supply in the long run. They are usually short-term credits given to struggling banks for a limited amount of time -- weeks or months. After this time, the creditors have to repay the loans, and the money disappears. At the same time, the willingness by existing banks to lend decreases, thus decreasing the money supply in the economy. The statistics by central banks show that the actual money supply M2 is growing a lot less slowly at the moment in spite of all the liquidity injections. Since the money supply is only growing very slowly at the moment, the inflationary pressures are low.
  3. The banking crisis is responsible for the overall slowdown in the EU's economy, and the German government is thus not responsible for having to adjust their growth estimates downwards sharply.
    Reality: Most indicators show that the slowdown started way before the crisis reached it's current urgence. The indicators started pointing down much earlier as a result of the heavy increase in energy costs, the appreciation of the euro (and the resulting loss in competitiveness), and Germany's botched reform of accounting rules for writing down investments in equipment. The banking crisis is just the latest "kick" -- but the three previous ones were all known early (and could've been partially corrected).
  4. This is the mother of all financial crises. This banking crisis is the worst crisis in several generations, up to the 1930's crash. Reality: Dramatic banking crises are more common than we think. Since 1970, the IWF has counted 42 crashes in countries like Argentina, Indonesia, China, Japan, Finland or Norway. In comparison to these crises, the current crisis isn't even very deep or expensive: The Paulson-bailout comes at a cost of 700bn, not even 5% of GDP, and only a fraction of this will be actually lost. According to the IWF, the average banking crisis in a country came at the cost of 13% of GDP for that country's tax payer. The Indonesian crisis even came in at four times this. The big difference to the other crises is that this one has caught on in the world's biggest economy, and as such reaches unknown dimensions in absolute terms.


Erin Ptacek said...

I should read foreign news more often. This is a nice perspective. Thanks!

Unknown said...

your numbers are off by an order of magnitude. GDP is 13T not 1.3...

halvar.flake said...

anshnd: I might be wrong, but afaik, in English, 1000bn = 1T, so 7000bn + 5500bn = 12500bn = 12.5T.
1 bn == 1000 million.

In German, the words a quite different:

1000 million =1 Milliarde (en:billion)
1000 millarden= 1 Billion (en:trillion)

Dave said...

Everyone (on the media and in the governments) is bemoaning the financial crisis. But what is it? No-one seems to be able to explain it clearly. It apparently started with the house mortgage crisis which occurred at a time when petrol prices for the average consumer were reaching relatively astronomical levels and daily announcements appeared in the press of gigantic salaries and bonuses being given to corporate leaders. Is there a connection? The house mortgage crisis started, we are told because mortgage interest rates were suddenly increased in the USA (why?), after house buyers had been initially loaned money by the banks at very low rates. Furthermore the money had been virtually thrown at house buyers, no questions asked and no attempt to check credit worthiness or ability to pay back, How dumb can you get? Where did all the money come from in the first place? The answer to this is probably bank customers. The economy was going well (at least psychologically) and people must have had enough to do some significant saving. The banks became flush and decided to invest their customers money in high risk enterprises. Anyway, back to the house buyers. The increase in mortgage interest rate was enough to tip them into a financially broke situation-i.e. Their incomes were no longer adequate to cover their increased payment demands. This shows how marginal these borrowers must have been. At this point banks were left with bad debt and houses they could not sell (why?) and started to lose billions (yes, I said billions). This shows how many buyers there were. This aspect still doesn't make any sense to me. There must have been a percentage of buyers who could still pay. An increase of say 3% on a monthly mortgage of $1000 is $30 which is not an outrageous extra amount to have to pay. Suppose we take an average house value of $200,000 ( this is $2X 10E5 to a mathematician which makes things easier to calculate later on) and then consider a loss of one trillion dollars (I think the banks claim they lost more than this), which is $ 1X 10E12 mathematically), then by dividing one number by the other we come to the number of houses 'lost'. This is 0.5X 10E 7, which is 5 million houses. As anyone can imagine this is a staggering number. Where are all these houses now? In fact it is inherently assumed that each house is worth $0 in the above calculation. If the houses are worth anything at all (which they must be) then the number is considerably higher.