The Price of Failure

I watched England knock themselves out of the European Championship last week - when they needed only a draw, on home ground, gifted the first goal to the visitors, a team that had already qualified. One could not have imagined a worst manner to lose. The head coach, Steve McClaren, must undoubtedly take much of the blame. If I were to discuss his ineptitude, I could easily go on for hours. But that is not the point here.

Mr McClaren defiantly refused to resign after the debacle when it was clearly the honorable thing for him to do. At least Kevin Keegan had the integrity to admit that he was not up to the job and resigned on his own accord. Instead, Mr McClaren waited for the FA to sack him the next morning, which was a foregone conclusion.

Where is the honour, Steve?

It was later revealed that Mr McClaren stood to receive 2.5 million pounds as compensation - or more than 7 million Singapore dollars for failing to get England past a supposedly easy qualifying group. The next morning at the press conference, a reporter questioned whether financial motivations were behind his refusal to step down. He denied it of course, what else could he have said? But his almost immediate purchase of a villa in the Carribean (reportedly costing 1.9 million pounds) spoke volumes of this man - one without honour. But McClaren was not an isolated case. Sven Goran Eriksson also received a large payout for his early termination of the contract, in the region of 6,500 pounds per day over a year for not working!

Golden Parachutes

Large as these payouts seem, they are truly peanuts compared to the Golden Parachutes in the financial sector. Merill Lynch's ex CEO received an astronomical US$160 million for getting the bank into the subprime mess. Citi's Charles Prince received a mere US$42 million but it was still too many zeros in my opinion. Never mind the large salaries society awards to superstar atheletes, movie celebrities or corporate movers and shakers. How on earth can people tolerate these kinds of payout for failing is something that truly escapes me.

The Measures of Inflation

Inflation in Singapore has gone up in recent quarters, prompting understandable anxiety amongst consumers. In the answer to a parliamentary question, the minister stated that consumers could choose cheaper alternatives to minimise the impact of rising prices. I shall not wade into the big debate whether it is a good enough or adequate answer, people have perhaps already made their minds up. But just to highlight some pertinent points concerning inflation measure since I have been reading some pretty inaccurate economics.

Suppose the price of pork goes up relative to fish, the rational utility maximising consumer will switch from pork to fish consumption. This is simply the substitution effect. But the basket of goods making up the Consumer Price Index (CPI) is often kept constant, and hence do not capture this substitution effect (Laspeyres Index). This is true therefore that this measure overstates the impact of price increase on the standard of living.

In other words, holding income constant, the standard of living does not fall as much as the increase in CPI suggests. The only case where the Laspeyres Index does not overstate actual inflation is when all goods in the basket have the same percentage price increase. In that case, there is no substitution effect since relative prices remain unchanged. Political considerations aside, the parliametary answer is essentially sound. Further reading can be found here.

Inflationary or Disinflationary?

Rising oil prices, falling US dollar, skyrocketing commodity prices all point to more inflation for the US economy, or do they? What about the effects of a slowing economy and falling house prices? Just a couple of years ago, the world was toasting to the Goldilocks US economy, growing without inflation, not too hot and not too cold. Now, it is a case of one foot hot and one foot cold, a real dilemma for central bankers.

Asymmetric Monetary Responses

The story went like this. The benign global economy transformed by the supply side revolution of China and other developing economies had brought great benefits in terms of output expansion. Interest rate stayed as low and for as long as they had been for a long time. Even though general consumer price inflation was low, asset prices like housing started to bubble over worldwide. The Greenspan doctrine was that it was too dangerous for central bankers to try to target asset prices, so they were left completely unchecked as the rest of the economy coasted along.

Suddenly there was the realisation that asset prices could no longer be sustained, and the bust came at a time when the world was beginning to face a supply side shortage. Commodity and consumer inflation started to rise, but assets began to deflate. It is easy to treat a patient with fever, give the medicine to bring the temperature down. It is equally easy to treat a patient with hypothermia, just warm him up. But what do you do to a patient with fever and hypothermia at different parts of the body at the same time? This is exactly Tinbergen's dilemma, how do you hit two targets with one arrow? You pray!

Cutting interest rates to support asset prices would risk sending inflation even higher. Not cutting would risk making the post-bubble financial turmoil worse. By December, we will know if Fed is indeed serious about the inflation fighting or is it really an emperor with no clothes. My personal assessment is that Fed will have to make more cuts, even if it strenuously denies it at the moment.

It is also here that the Greenspan doctrine ties itself to intellectual knots. To leave asset price rises unchecked, while opening the door for interest rate cuts and bailouts when asset prices fall is exactly the kind of policy asymmetry that leads the market into making one-sided bets. Revisionist talk this is not, many economists have long been arguing that monetary policies were too loose too long.

Risks for Rest of the World

As difficult a job as the one Bernanke is doing, we have to remember this. When Fed weighs in on its monetary policy stance, it cares only of the risks facing the US economy. Given how dependent the rest of the world is on the US, this is an extraordinary situation. By cutting interest rates and driving US dollar ever lower, it places severe strains on economies elsewhere. Those countries pegged to US dollar will face either higher inflation, or will have to abandon the peg altogether, both of which will lead to more financial turmoil.

The Euro and Pound are both soaring relative to the US dollar at a time their own economies are too entering the down cycle. Just yesterday, French President Sarkozy fired off a warning shot that US could not expect to devalue its way out of trouble of its own making, and implicitly threatened competitive devaluation. While he in reality did not have control over the ECB, he very much captured the mood over in Europe. The sense was that the European economies were at the short end of it all, being punished for someone elses' sins.

What we have seen in the past three months is probably only the beginning act of a period of economic turbulence.

Not a Short Downturn

Two months ago, I suggested that markets were overly exuberant after Fed's first rate cut, which if you recall sent US and local stock markets to record highs - as if the subprime problem never occurred. The market rallied, and for two months I was wondering if I was missing out on something. But the problems associated with the US housing market have not gone away. The US financial system and overall economy cannot return to good health before the housing market problems are worked off.

Property as a Collateral

Compared to other assets, housing property is very unique. A large section of the population own it, with most people taking out mortgages in the process, using the purchased property as the collateral. If you buy a $1 million house and borrow 80 per cent, your net worth is $200k. A 10 per cent increase house prices will increase your net worth by 50 per cent, while a 10 per cent fall in price has the opposite effect of minus 50 per cent.

Conversely, a 10 per cent decline in the stock market does not have the same macroeconomic ramification since not many people own shares directly. More pertinently, not many people borrow or leverage to buy shares.

The effect of using property as a collateral is that small changes in house prices can have a large impact on the net worth on many people, and its macroeconomic impact therefore significant. As the net worth of individuals falls, many activities in the economy are dragged down with it. For example, if an entrepreneur has taken out a loan against his property to fund his business (like many small businesses initially do), a housing downturn will have financial consequences for the business itself.

For most consumers, the wealth effect - and even the psychological impact of falling house prices - will lead many to cut back on consumption. The bad loans on the banks' books will force them to cut back on lending as well, hence the credit crunch.

Feedback

What compounds the problem is the feedback effect. The effect of more foreclosure is to send housing prices even lower, hitting the net worth of families with previously healthy financial balances. A LSE Professor Kiyotaki - now in Princeton - modelled this effect. Because of this feedback effects, the initial shock is propagated, resulting in dramatic, and prolonged, negative impact on the rest of the economy which is unlike stock market corrections. It is for the same reasons why Japan took so long to recover from the asset bubble. If you recall, Singapore's economy also took rather long to work of the excess of the last property bubble.

Alan Greenspan has repeatedly warned that the housing inventory in the US is still very large. There is still an estimated 9 months' worth of excess supply, not including those property put on fire-sale in the market. Overall, US housing prices have fallen only very little (average of about 5 per cent or so), and there is therefore a long way to go potentially. Some metropolitan areas in the US are expected to see at least a 20 per cent price decline. It is going to hit the families, banks and financial system hard.

On and off, we will no doubt get some good news to push the markets up a little but have no illusions about it: this US downturn will not be a short one.