The Deeper the Downturn the Quicker the Recovery

The Deeper the Downturn,
The Quicker the Recovery
By CHRISTOPHER WOODArticle
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This is no time to gloat, since jobs are being lost, wealth is being destroyed, and famous financial service franchises are disappearing from the world stage. But by refusing to come to the aid of Lehman Brothers, U.S. Treasury Secretary Henry Paulson has done the right thing, in terms of seeking to end the insidious cycle of federal-government bailouts, closet or otherwise.

In this respect, Mr. Paulson has started to draw the line on the extreme socialization of credit -- and resulting extreme moral hazard -- that was a legacy of former Federal Reserve Chairman Alan Greenspan.

Despite the chorus of chatter coming from the "experts," there is no easy way out of the inevitable deleveraging that is the consequence of the gargantuan leverage that Wall Street and indeed the City of London regarded as "normal" in recent years. Remember that Lehman began this year with a balance-sheet geared over 30 to 1.

The primary reason for such insane levels of leverage was, of course, the extreme moral hazard encouraged by the Fed under Mr. Greenspan. The second reason was that the men running these firms clearly had no understanding of the risks they were taking in the complex world of structured credit and asset-backed securities.

The Western world must now face the downside of what Irving Fisher memorably described as "debt deflation." This is not a pleasant process: It means declining asset prices. But it is ultimately a healthily cathartic one, as Asia and Japan have discovered over the past decade.

There has been a conceit on the part of Western central bankers in recent years that they could somehow avoid this deflationary outcome -- despite their consumption-driven economies' addiction to leverage, be it in America, Britain or Australia -- because of their supposed superior skills in implementing the techniques of mechanical monetarism. But as these technocrats are starting to find out, it is not as easy to inflate one's way out of a deflationary debt bust as they have always seemed to imagine.

That will not stop them from trying, which is why interest rates will be cut aggressively across the globe in the next six months. So the inflation scare of the first half of 2008 is over, and with it all fashionable talk about "a return to 1970s stagflation." However, the credit crisis is not yet over; there is probably another $1 trillion of write-offs globally in addition to the $500 billion-odd announced so far. In this sense ice has prevailed over fire.

But at least the markets are now beginning to see signs of capitulation, as well as stronger financial franchises emerging to buy weaker ones. This is encouraging. The best example is Bank of America stepping up to buy Merrill Lynch, a firm with a formidable franchise in U.S. retail stock selling.

It is also rational behavior that cyclical stocks have recently begun underperforming financial stocks, even as the scare stories about individual financial firms escalate. The market is saying that the credit crunch will now inflict an inevitable toll on real economic growth. This is also why oil is collapsing and government bonds are rallying.

What about Asia? Stock markets there are being hit by the collateral damage from the West. Growth will undoubtedly slow, perhaps to 8% in China and 7% in India. But there is no reason for a systemic collapse in Asia; the region does not have the financial leverage issues that are the fundamental cause of the financial crisis in the West.

Asia learned all about the downside of debt 10 years ago. Like other emerging markets, Asia also has dramatically less exposure to the curse of securitization run amok, since regulators have maintained a healthy old-fashioned preference for deposit-funded banking systems.

Regulators in the West are now belatedly discovering old-fashioned virtues. The failure of Lehman Brothers will prove the catalyst long needed to precipitate the painful but necessary collapse of the shadow banking system, however deflationary that process.

The only consolation from the pain ahead is that the deeper the downturn, the quicker the recovery. Asia discovered this truth in the late 1990s, but Washington politics will likely prevent such a V-shaped downturn. This means bad debts may be warehoused, Japanese-style, resulting in an extended period of lackluster growth in the U.S. -- and indeed in Euroland, where financial problems are almost as critical, if rather less transparent.

The preferred policy in the U.S. should be a new Resolution Trust Corporation, which emerged in the wake of the savings-and-loan crisis of the 1980s, and which sold distressed assets. This is the opposite of what Mr. Paulson announced last week regarding the monstrous hybrids, Fannie Mae and Freddie Mac, where the U.S. Treasury pledged to buy Fannie- and Freddie-guaranteed mortgages, thereby further putting U.S. taxpayers on the hook.

Still, one point is clear. Policy makers should stop pretending there are easy options. Mr. Paulson has at least started in this direction -- after more than a year when virtually every major central banker, every major finance minister and every major banking regulator has been consistently wrong in his predictions. It is time for some humility in the face of the corrective actions of the markets.

Mr. Wood, equity strategist for CLSA Ltd. in Hong Kong, is the author of "The Bubble Economy: Japan's Extraordinary Speculative Boom of the '80s and the Dramatic Bust of the '90s" (Solstice Publishing, 2005).