Panic Seize Markets

A week of living perilously

By Martin Wolf in London

Published: November 21 2008 18:43 | Last updated: November 21 2008 18:43

Panic seized markets this week. Just one asset class is deemed safe: the liabilities of highly-rated governments.

The price of a barrel of oil is below $50. The dividend yield on the S&P 500 is higher than the yield on US 10-year treasuries. The yield on short-dated US inflation-indexed bonds is higher than on their conventional equivalents. The yield on ten-year government bonds is now 3.2 per cent in the US and 3.8 per cent in the UK.

This is pricing for deflationary Armageddon. The fundamental rule of investment is: buy when others are frightened and sell when others are confident. The economic position looks ghastly. But, at least for those with sufficiently long time horizons, the investment position does not.

Yet good economic news is likely to take a long while in coming. All the principal advanced countries are now in recession. According to the November Consensus Forecasts, gross domestic product is forecast to contract in the advanced countries next year, with world growth down to a miserable 1.1 per cent. It is almost certain to end up lower still – perhaps with a reduction in global output.

Meanwhile, the financial system remains dysfunctional. With liquidity still hoarded by banks, heavily indebted investors – hedge funds and private equity funds – are compelled to retrench. So-called “carry trades” – inherently absurd notions – are imploding, generating flight back to lower-yielding currencies, principally the yen and the dollar.

The leverage machine is operating in reverse and, as it generated fictitious profits on the way up, so it takes those profits away on the way down. As unwinding continues, highly indebted consumers cut back, corporations retrench and unemployment soars. Round after further round of losses befall the lenders.

Yet governments are not helpless. They can continue to recapitalise financial institutions. The entire funding of the US TARP – the “troubled asset relief program” – should be used for this purpose. It is ridiculous to conserve ammunition until after the battle is lost. But banks must also be forced to lend. Today, everybody is losing out, because lenders are too cautious, just as they loved risk two years ago.

As the deflationary danger comes closer, central banks can finance anything – above all, government borrowing. This will work much better, however, if all countries act together. For surplus countries with limited financial fragility to choose this moment to creep willingly into recession – thereby exacerbating the difficulties of the indebted, on whose demand they depended – is economic vandalism.

Deep depressions deliver not healthy cleansing of excess, but social and political catastrophe. The time for aggressive countervailing action is now. Patient investors may be able to wait for a long term reward. The rest of the world cannot.