Ambrose Evans-Pritchard: Blame central banking, not capitalism


Capitalism Not to Blame for Debacle

By Ambrose Evans-Pritchard
The Telegraph, London
Tuesday, August 21, 2007

The witch hunt has begun.

French president Nicolas Sarkozy has vowed to hunt down the "speculators." Germany's Angela Merkel is eyeing laws to curtail hedge funds. Brussels has launched a probe of the rating agencies, suspected of sticking "AAA" and "AA" grades on sub-prime debt for venal motives. The US Congress is orchestrating a show trial of "predatory lenders."

The blame-game was ever thus. Wall Street bankers were hounded after the 1929 crash; some went to prison. But if you track down the root cause of this credit bubble -- now popped -- the "blame" lies with Asian, European, and Anglo-Saxon central banks.

They created this mess, if that is what we now face. It was they -- in effect, governments -- that intervened in countless complex ways to push down the price of global credit to levels that warped behaviour, as the Bank for International Settlements has repeatedly noted. By setting the price of money too low, they encouraged debt and punished savings.

The markets merely responded to this distorted signal with their usual exuberance. Private equity was tempted to launch a takeover blitz at a debt-to-cashflow ratio of 5.4 because debt was made so cheap. The US savings rate turned negative because interest rates were held below inflation.

Untangling the varied causes of this credit debacle is not easy, but the central banks of Asia and the developing world have surely played a key role by hoarding reserves. Their motive is either to hold down currencies or to ensure that they need never again suffer bitter medicine from the International Monetary Fund.

The sums are staggering: China $1,330 billion (£670 billion), Japan $924 billion, Russia $414 billion, South Korea $251 billion, Taiwan $266 billion, India $229 billion, Brazil $147 billion, Singapore $144 billion, Malaysia $98 billion, Thailand $73 billion. Compare this to US insouciance, $67 billion.

These reserves have risen from $3,000 billion in 2003 to $6,700 billion today. The vast bulk has been invested in G-10 government bonds or agency debt -- although some countries are switching to sovereign wealth funds able to invest in equities and property.

The effect has been to drive down global bond yields, with effects spilling into the mergers and acquisitions market, Latin American debt, and, of course, US property. It is why the spreads on corporate bonds reached the lowest ever recorded in February this year. The iTraxx Crossover index of low-grade debt reached 162, while the spread on Brazil's bonds fell to 138 -- a wafer-thin margin over "AAA" benchmarks.

Pension funds and insurers are often compelled to buy "AAA" bonds, yet the yields on offer have not been enough to meet their long-term liabilities. So when the alchemists hawked tranches of "senior" US sub-prime debt -- and car loans, etc. -- that had been packaged into securities (collateralized debt obligations, or CDOs) with an "AAA" or "AA" rating and a bumper yield, they could hardly resist. Some $470 billion of CDOs and $524 billion of "synthetic" CDOs were issued last year, BIS data shows.

So while the investment boutiques -- Bear Stearns, Morgan Stanley, Deutsche Bank, Lehman Brothers -- may have pushed a toxic product (a rash of lawsuits will decide), this occurred in a context where policy error had bent incentives.

In parallel, the Bank of Japan held interest rates at zero for six years until July 2006 to stave off deflation. Even now, rates are still just 0.5 percent. The BoJ also injected some $12 billion liquidity every month by printing money to buy bonds. The net effect has been a massive leakage of money into the global economy.

Faced with a pitiful yield at home, Japan's funds and thrifty grannies shovelled savings abroad. Banks, hedge funds, and the proverbial Mrs Watanabe were all able to borrow for near nothing in Tokyo to snap up assets across the globe. BNP Paribas estimates this "carry trade" to be $1,200 billion.

Faced with an asset shock coming from Asia, the Federal Reserve and the European Central Bank could have taken counter-action. They did not do so. Nor did they tighten much to offset liquidity being "created" by the new-fangled credit instruments. The Fed held rates at 1 percent until June 2004, when the economy was growing at 5 percent. The ECB kept rates at 2 percent until December 2005. It takes 18 months or so for monetary policy to exert its full effects. The bubble peaked in early 2007.

The central banks have said their task is to fight inflation, not to police asset prices. Critics retort that the US asset bubble in the 1920s and Japan's bubble in the 1980s both occurred at a time of low inflation. Belatedly the Bank of Japan, the ECB, the Swiss, the Scandies, and the Bank of England are questioning the wisdom of ignoring asset prices, deeming it wise to "lean into the wind" to slow excesses. But it is very late in the day. The credit bubble is already with us.

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