Monday, 27 October 2008

'We need to have a recession'

This time last year, Charles R Morris was wrapping up ‘The Trillion Dollar Meltdown’, a prescient primer on the credit crash. A paperback edition planned for February ups the ante with a revised title: ‘The Two Trillion Dollar Meltdown’. What the US needs most, he says, is a brutal recession to throttle its debt-fuelled buying binge.

“We need to have a recession — a sharp one and a deep one,” says Mr Morris, 68, a ruddy-faced lawyer, former banker and prolific financial writer. He walked me through his revised numbers during an interview in Bloomberg’s Manhattan offices.

Mr Morris’ original calculation that the crisis will result in at least $1 trillion in losses to the banking and other investment sectors assumed an orderly unwinding, which he had predicted wouldn’t happen. Events have proved him right.

The dominoes keep falling — which bank will be next? — amid rising writedowns and losses that already total $660 billion, according to data compiled by Bloomberg. The rescue plan that US treasury secretary Henry Paulson pushed through Congress has yet to stop the rot.

“Since the Paulson plan implicitly assumes a continuing stream of bank losses on roughly the same scale for the foreseeable future, the likely losses are now $2 trillion or even more,” he writes in the revised foreword of a new electronic edition of his book.

The $700-billion bailout emerged from what Mr Morris calls “the caffeinated fog of a frenetic two weeks” that included the bankruptcy filing of Lehman Brothers Holdings, the rescue of American International Group (AIG) and the “night-time elopement” of Merrill Lynch & Co and Bank of America.


Though Mr Paulson’s plan may help ease cash hoarding at banks, it perpetuates the misconception that “we have a liquidity problem, not a solvency problem,” Mr Morris says, leaning forward in his plaid jacket and chopping the air with his hand to emphasise the words liquidity and solvency.

To explain the difference, Mr Morris cites two precedents: The rise of US grain futures in the 19th century and the tulip bulb mania that gripped the Netherlands in the 17th century. “In the 19th century, we had these huge wheat fields in the Midwest,” he says. “But it was very risky to send grain to the East, let alone abroad.”

That was a liquidity problem, and the development of grain futures markets solved it by allowing future deliveries to be sold for cash. As this “fire hose of investment” flooded the grain belt, “we became the Saudi Arabia of food,” Mr Morris says.


During tulip mania, by contrast, traders leveraged up their bulb holdings, taking ever more risk until the bubble burst and prices collapsed. No amount of lending could have restored them, Mr Morris says; the episode was “a parable of insolvency.”

“It wasn’t a liquidity problem,” he says. “You don’t solve that by lending more against tulip bulbs.’

US houses, in short, became tulip bulbs. Banks that forked over cash for a claim on a home’s unrealised value were in essence “selling tulip bulb futures.” The more cash they extended, the more US consumers spent.

“Between ’00 and ’07, total US gross domestic product (GDP) was $92.5 trillion in current dollars,” Mr Morris says. “Our gross domestic purchases were $97 trillion, a $4.5 trillion overrun.”

Where did the $4.5 trillion come from? Consumer debt — almost all of it secured by houses, Mr Morris says. “Between ’00 and ’07, homeowners borrowed $4.2 trillion on their homes that they didn’t invest in their housing or use to pay down their mortgages,” he says.


Personal consumption jumped to an unprecedented 72% of GDP by ’07 from a long-term average of about 66%, Mr Morris says. The upshot: “a false prosperity based on a huge waterwheel of money, fuelling a debtfinanced, import-driven consumer binge,” as he puts it in the new foreword.

When other countries gorged on debt, the US lectured them about the need for austerity, he says. Mr Paulson and Federal Reserve chairman Ben Bernanke, by contrast, are pumping hundreds of billions of dollars into the system. “They’re attempting to avoid a recession,” he says, whispering the R word. “It will make things worse.”

Mr Morris urges the US to instead engineer a recession, as former Federal Reserve chairman Paul Volcker did when he slew runaway 1970s inflation by raising interest rates as high as 20%. Though Mr Volcker’s shock treatment was rough, the US is resilient, Mr Morris says: “We earned it back fast.” “Do what Volcker did,” he advises. “We can get out of this crisis hard and fast or painfully slowly.”

Source: EconomicTimes

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