Belmont Club

Which way did he go, George?

Brad Setser at the Council of Foreign Relations looks at how the world’s leading economies performed in the last quarter of 2008. Short answer: they tanked and now we know. The chart on his site shows the US is by no means the worst off.

The G-7 countries are all contracting. And, alas, a host of emerging economies are contracting even more. It shouldn’t be a surprise that Merrill has joined BNP Paribas in forecasting that global growth will dip below zero in 2009. The big issue globally is how to shift out of the current dynamic, one where weakness in demand in one country generates further weakness in all of its trading partners — and one where financial losses in one part of the globe trigger reductions in lending throughout the world, and thus add to the global credit crunch.

Setser also looks at what the records show about what China knew in late 2008 and it turns out that they too were more surprised by the turn of events that at first believed. They were actually expanding their portfolio in equities even as the bubble started to go blat. Setser thinks it is possible that China is hurting more than it is letting on, though there is no way to be sure. But at any rate, neither Chinese totalitarianism nor European social models seem to confer any particular insight into the future.

It turns out that China bought significantly fewer Treasuries from the middle of 2007 to the middle of 2008 than I had projected – and a lot more equities. China also was – as expected – a very large buyer of Agencies (particularly mortgage backed securities with an Agency guarantee, often called “Agency pass-throughs”) from mid-2007 to mid-2008.

China consequently entered the “Lehman” crisis with a somewhat riskier portfolio than I thought. The bulk of China’s portfolio, to be sure, was in Treasuries, Agencies and comparable European bonds. But it now looks like well over 10% of SAFE’s portfolio was invested in “risk” assets of various kinds — equities and corporate bonds.

That likely explains why China reversed course and fled to safety this fall. China got burned. SAFE (not-so-SAFE?) especially. …

SAFE may have gotten authorization to have put more than 5% of its portfolio in equities. Given the size of SAFE’s portfolio, that meant that SAFE was one of the largest sovereign investors in US equities even thought it wasn’t formally a sovereign wealth fund. Only ADIA obviously has larger holdings of US equities.

And, well, it is quite likely that China’s $90b of equities aren’t still worth $90 billion now. In aggregate, SAFE likely took larger mark-to-market losses on its equity portfolio than the CIC took on Blackstone and Morgan Stanley.

I suspect that SAFE is still carrying its equity portfolio on its books at their purchase prices, which implies that it is sitting on a quite large loss. But I don’t have total confidence on this. SAFE supposedly reports the book not the market value of its bond portfolio, but I am not sure how it accounts for its equities. It is possible that the rise in the value of SAFE’s Treasuries helped offset the fall in the value of SAFE’s equities.

China’s surprise bears on the key question Setser raises in the first instance. “The big issue globally is how to shift out of the current dynamic, one where weakness in demand in one country generates further weakness in all of its trading partners — and one where financial losses in one part of the globe trigger reductions in lending throughout the world, and thus add to the global credit crunch.” The China anecdote reveals that however we intend to do this, we’ll have to do it on the basis of imperfect and lagged information, because right now nobody has a clear crystal ball. We can’t even measure where we are with great precision. In this case we don’t know how badly China is hurting, or even if it is. Since the crystal ball doesn’t exist, we’ll have to create one. Find better ways of keeping our perceptions and reality in coherent sync. Otherwise we shouldn’t be surprised if an unwelcome revelation of China’s balance sheet sets off another selloff cycle again.

Setser intriguingly links to an academic paper by Adrian and Hyun, whose precis says “In a financial system where balance sheets are continuously marked to market, asset price changes show up immediately in changes in net worth, and elicit responses from financial intermediaries, who adjust the size of their balance sheets. We document evidence that marked to market leverage is strongly procyclical. Such behaviour has aggregate consequences. Changes in aggregate balance sheets for intermediaries forecast changes in risk appetite in financial markets, as measured by the innovations in the VIX index. Aggregate liquidity can be seen as the rate of change of the aggregate balance sheet of the financial intermediaries.” Near as I can tell, what that summary means is that there’s a feedback loop between the perceived value of the economy, as measured by balance sheets, and the risk profile of the financial system. In other words, the good times inspired unwonted optimism. The unanswered question is whether the bad times also cause unwarranted panic.  That suggests that global economy may have been stampeding itself into a bubble in the past and may now be stampeding itself into catastrophic deflation. Nobody was exempt. Once China’s SAFE and CIC “saw” what was around the corner, they fled in the opposite direction, just like everybody else.

If you can create a self-stampeding system that runs off on the wrong tangent then we have serious information problems. The quantity of information we have to hand underpins what we call “confidence”. Confidence is qualified not only by what we know, but by what we don’t know. And there’s a lag between the time when some investors realize the true facts and the rest of the world catches on. This probably accounts for what Niall Ferguson in the lecture I linked to called the Wile E. Coyote effect, when the world ran apparently along its normal trajectory in 2008 until it looked down and realized there was nothing underneath it but air. That wasn’t a loss of ‘confidence’ so much as a belated ‘realization’. It’s as if the last bits in a message we thought beckoned us to a party came through and it invited us all to a funeral.

This only strengthens the argument for shortening the feedback loop in any attempts to “shift out of the current dynamic” because the steps we can rationally take can never drastically exceed our information holdings. If we get much past that horizon, then we really acting on belief and not science. Ideally, we should neither take the counsel of our hopes nor our fears but calculated risks. We should act within the limits of what we know. If we are dissatisfied with those limits, then we should act to extend them. Not boost ‘confidence’ which is meaningless without being qualified. Otherwise we’ll be like Bugs Bunny, who disoriented by a blow to the head by a Gremlin, seeks guidance from a nonexistent ‘George’. As in, “which way did he go, George? Which way did he, go?” Guys, he went that a way.