Sent: 27-05-2010 08:06:03
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What We Leaned from 2008
The spreading European economic malaise harks back to the lessons of 2007 and 2008 and initial errors about how serious the sub-prime crisis would become. It is tempting to draw parallels between now and what happened two years ago.
Among the lessons thrown up by the global credit crisis in 2008 and its surrounding events, four stand out.
1. First round financial market effects appeared more manageable than they eventually proved to be. The initial evidence of the U.S. real estate market weakening in 2007 was treated much like a normal cyclical adjustment. Subsequently, many analysts responded to the imminent sub prime market collapse by concluding that sub prime assets were such a small part of the total bank asset base that the possibility of widespread failure could be downplayed. Now we know that a single asset can have a hugely disproportionate influence: there is no limit to the value of derivatives that can be created and linked to it.
2. Adjustment does not occur smoothly. The pressure to adjust builds over time. Eventually the dam bursts. The build up to the real estate market crunch came over many years. There was then a full year between the first signs of U.S. recession and the initial signals of a broader systemic problem emanating from the financing of real estate which eventually resulted in the collapse of financial markets.
3. Technology is playing a bigger role as it speeds up trading and allows growing trading volumes in ever shorter periods of time.
4. The herding tendency in markets is alive and well, abetted by technology and ever widening market access. Swift reactions are required once a market move begins because the whole world has access to the same information simultaneously, for all practical purposes. It is frequently easier to join the herd rather than risk taking the time to make an independent judgment. Market herding leads to dramatic turning points.
If we extrapolate the 2008 experience, we could expect four consequences.
1. Greece might not actually be the first domino to fall. Its debt problems will entangle European banks and possibly banks elsewhere as we discover previously unsuspected connections between Greece's debt and international investors.
2. The euro will unravel creating chaos for everyone who has written a contract in a defunct currency.
3. The worst of the impact on financial markets will eventuate no earlier than 2011 when the full significance of these connections becomes apparent and when there will be a speedy and severe decline in equity values.
4. The loss of equity market value will signal buying opportunities ahead since a recovery, when it gets going, will be equally as dramatic.
We often fall into the trap, however, of putting too much emphasis on recent history in forecasting the period ahead. It is not necessarily the most relevant experience simply because it is the most recent and the most clearly recalled.
Comparing a country to a bank is erroneous. No matter what happens, something called Greece will continue to exist. The same cannot be said of Lehman Brothers.
The second crisis is often easier to deal with than the first. Surviving the systemic shocks of 2008 braces us psychologically. Having survived once, it becomes easier to believe that we will survive again. A European contagion will seem less severe and we will feel more confident about coping with it.
Of course, the biggest difference between now and 2008 is that policymakers have used up so much economic firepower in coping with the first crisis. Dramatic interest rate reductions, massive fiscal stimulus programs and unprecedented central bank asset purchases will not be such serious options in the coming two years (or even for another ten).
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