Tag Archives: Financial crisis

Updates from Chicago Booth

Who is right about inflation?
The US Fed and consumers have very different expectations about the future
By Brian Wallheimer – Inflation chatter started heating up this spring, along with inflation itself. In April 2021, the US Consumer Price Index, which measures how fast prices change, rose at a 4.2 percent annual rate, more than double the usual target rate. Then in May, the inflation rate soared to 5 percent. With the worst of the pandemic seemingly easing, US consumers were apparently venturing out again and spending at a fast clip.

The figures took inflation watchers off guard. The Wall Street Journal’s editorial page noted that Federal Reserve chairman Jerome Powell had wanted some inflation but would likely be surprised by the force of April’s numbers, saying, “Powell’s inflation ship has come in, albeit more rudely than he probably wanted.”

Financial journalists and investors, always looking for signs of how the central bank will react to signs of inflation or deflation, kicked into high gear, trying to anticipate the timing of any Fed actions.

But consumers—who actually drive inflation—seemed unfazed, apparently already operating with the understanding that prices were rising fast, and would continue to do so. Homeowners remodeling their homes during the pandemic were aware of historically high lumber prices. Home cooks felt the impact on food prices. Buyers of both new and used cars saw prices surge due to a shortage of computer chips. more>

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Lebanon’s public debt default

By Ilias Bantekas – The nature and causes of sovereign debt differ from one country to another. Yet, the popular or engineered narrative of debt usually conceals its true origin or cause.

In the case of Lebanon, currently facing a financial and economic crisis ranked by the World Bank as possibly among the top three most severe global crises episodes since the mid-19th-century, one of the key lessons from the Greek experience is the importance of understanding the cause. The truth about how and why Lebanon reached the current debt crisis, including its suspension of a $1.2 billion Eurobond payment in March 2020, must precede any step toward recovery and restructuring under current solvency conditions.

A look at the Greek experience

At the time of Greece’s sovereign debt crisis, the popular narrative was that successive Greek governments had augmented the public sector and had exceeded their finances. This further supports the popular myth that people in the south of Europe are lazy, take long siestas, aspire to be civil servants, and that their governments are corrupt. Even so, an independent parliamentary committee set up in 2015 disproved this narrative.

The committee’s extensive findings clearly showed that the Greek public sector was the lowest spender among its then 27 European Union counterparts (apart from defense-related expenditures). In fact, until the beginning of the global financial crisis in 2008, Greece’s debt-to-GDP ratio was one of the lowest in Europe and certainly sustainable. So, why did it shoot through the roof the following year? This is because Greek banks had accumulated private debt (in the form of loans) to the tune of about €100 billion.

At the time, Greek banks had largely been acquired by French and German banks and hence the private (and now unsustainable) debt of Greek banks was about to become a Franco-German problem. Instead of this happening, the then-Greek prime minister was ‘convinced’ to nationalize Greek banks and thus transform a purely private debt into a public one. By so doing, it was now the Greek taxpayer that was saddled with the debt and the ensuing austerity this entailed, while Greek banks were restructured (effectively re-financed) and France and Germany were relieved. more>

Updates from Chicago Booth

The cycle behind sovereign debt disasters
By Michael Maiello – In theory, sovereign debt can be a healthy part of a growing economy. Governments can borrow from creditors to fund trade deficits, importing goods from other countries so their citizens can buy the products and enjoy the benefits.

While that may be the idea, the results of such borrowing are generally disastrous, warns research by Stanford’s Peter M. DeMarzo, Chicago Booth’s Zhiguo He, and Copenhagen Business School’s Fabrice Tourre. There is no default plan for a sovereign borrower the way there is for, say, a corporate one—and borrower countries have proven unable or unwilling to commit to anything like one. Without the disciplining force of covenants, which are common in private-sector borrowing, the system doesn’t wholly account for the risks associated with economic booms and busts, which works against strategic, responsible borrowing.

The trio’s work on sovereign debt risks rests on a foundation of work by DeMarzo and He on private-sector debt, in which they describe the tendencies of corporations to borrow without restraint when they do not pledge collateral to specific lenders. As uncollateralized borrowers tend to issue debt in good times and bad, lenders demand ever-higher borrowing costs over time, erasing the benefits to the borrower company and increasing default risk. Collateral adds discipline to the process. In another study, DeMarzo argues that sovereign borrowers should pledge assets to creditors as collateral in the event of default. This latest research, with He and Tourre, suggests that such collateralization could crystallize the consequences of default and break the debt cycle that is so costly to so many citizens. more>

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Why Investors Shouldn’t Worry About Slowing Growth

Despite talk of a “growth scare,” the U.S. economy and markets may be poised for steadier gains ahead.
By Lisa Shalett – These days, we are seeing some of the classic indicators of a transition into the middle phase of an economic cycle: Year-over-year comparisons of growth measures and corporate earnings are cresting. So, too, are economic surprises, or the rate at which data is beating forecasts.

As economic growth moderates, uncertainty has risen and a “growth scare” narrative has begun to take hold among some investors. The market’s rotation toward defensive and secular technology stocks indicates that investors’ outlook on economic growth is dimming. There also seems to be worry that the Federal Reserve might start to taper its stimulative asset purchases earlier than expected, a concern seen in the U.S. Treasury market as the gap between short- and long-term yields narrows. Some pundits are even warning of a return to 1970s-style stagflation, a difficult period of high inflation and slow growth.

These may be popular market sentiments, but we remain convinced that a growth scare is overblown. Here are three reasons why:

  • Although economic growth is slowing from the extreme comparisons of last year’s trough, it remains solid. Recently, preliminary estimates for second-quarter gross domestic product (GDP) growth came in at 6.5%. And Ellen Zentner, Morgan Stanley’s chief U.S. economist, forecasts third-quarter annualized GDP growth at 6.1%, expecting that supply-chain pressures will continue to resolve and fiscal spending prospects will turn up. Strong fundamentals also underpin this forecast: Recent data updates saw U.S. manufacturing activity grow, housing prices rebound and durable goods orders advance.
  • Second-quarter corporate earnings have been excellent so far. As of July 30, with 59% of S&P 500 companies having reported results, 88% of them have reported earnings that came in above analysts’ expectations, and 88% have reported a positive revenue surprise. Looking ahead, analysts are projecting double-digit earnings growth for the remaining two quarters of 2021.
  • The consumer remains strong. U.S. consumer confidence as measured by the Conference Board Consumer Confidence Index inched up slightly in July, to 129.1, the highest since February 2020. Stable confidence and rising wages, together with growing household wealth and ample savings, should keep consumer spending strong.

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Economist Dennis Snower Says Economics Nears a New Paradigm

Beyond any shadow of a doubt, there is a change in the air, as economics nears its Copernican Moment.
By Dennis J. Snower – This is probably the most exciting and fruitful time ever to become an aspiring economist. Why? Because economics is reaching its Copernican Moment – the moment when it is finally becoming clear that the current ways of thinking about economic behavior are inadequate and a new way of thinking enables us to make much better sense of our world. It is a moment fraught with danger, because those in power still adhere to the traditional conventional wisdom and heresy is suppressed.

Up to the 16th century, the conventional wisdom on astronomy conformed to Aristotle’s cosmology and Ptolemy’s astronomy. In Aristotle’s system, the earth is the center of the universe and the heavenly bodies are part of spherical shells of aether. These shells fit around one another in a clear order: Moon, Mercury, Venus, Sun, Mars, Jupiter, Saturn, and the fixed stars. All these spheres are put in motion by the Prime Mover. By the 16th century, Ptolemy’s astronomy was regarded as in accord with the conventional reading of the Bible, the ultimate source of all knowledge.

Ptolemy’s system encountered endless difficulties in accounting for the empirical evidence, which were addressed through the repeated application of geometric “fixes” (eccentrics, epicycles, and equants). The underlying methodological requirement was to retain the Aristotelian system as the foundation for our understanding of the universe and then to depict each “fix” as a divergence from this accepted foundation. Thus, to be taken seriously as an astronomer, it was necessary to master the Aristotelian and Ptolemaic systems and to develop superstructures on them. Copernicus did not follow this intellectual path, but he did not dare to publish his heliocentric theory until the year of his death, in 1543. In 1632 Galileo published a book supporting Copernicus’ heliocentric theory, was summoned before the Inquisition, and recanted. The Church had the hard power of the Inquisition and the soft power of scholastic theology on its side.

In the academic discipline of economics, we are currently experiencing a tame analogue to these first throes of the scientific revolution. The punishment for heresy is not execution, but intellectual oblivion. more>

Rising Inflation: More Than Just Transitory?

Why investors shouldn’t dismiss recent upside surprises in U.S. inflation as a temporary phenomenon and how they can recalibrate their strategy.
By Lisa Shalett – Investors who braced for a sharp rise in April’s U.S. inflation readings from last year’s muted levels early in the pandemic were still surprised by the 4.2% year-over-year surge in the consumer price index (CPI)—double the highest projection in a Bloomberg survey of economists, even after hints in March of a coming uptick.

The CPI data released last week weren’t the only concerning indicators of inflation’s resurgence. The producer price index, which tracks wholesale and manufacturing costs, increased by 6.2% year-over-year in April—the highest reading since the U.S. Bureau of Labor Statistics started tracking the data in 2010—after rising 4.2% year-over-year in March. Perhaps most concerning, these moves came with strong gains in the “core” readings, which strip out volatile commodity-related drivers, such as food and energy prices.

While many, including the Federal Reserve, see the jump in prices as “transitory,” we believe it’s much more than just a blip. To be sure, some short-term inflation drivers, such as supply-chain bottlenecks, are likely to subside. However, we believe this post-pandemic business cycle has ushered in a new period of sustained higher fiscal spending, higher inflation and rising long-term interest rates. In particular, we see five secular shifts that could contribute to this dynamic, each of which can be summed up using terms that begin with the letter D:

  • Deglobalization: In the past decade, globally optimized supply chains helped to check price inflation. Now, the COVID-19 pandemic has likely sped up a shift toward deglobalization that could return supply chains to the U.S., which could contribute to consumer price inflation.
  • Deficits: Federal debt and deficits are exploding in the wake of unprecedented amounts of stimulus meant to counter pandemic disruptions. With the Fed essentially buying new government debt, dramatic growth in the money supply could be inflationary.
  • Dollar debasement: More stimulus to keep long- and short-term rates low would likely drive inflation through further declines in the value of the dollar against other major currencies.

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Updates from Chicago Booth

Do we need a Chapter 11 for banks?
By Emily Lambert – When the retailer Sears filed for Chapter 11 bankruptcy in 2018, it came as little surprise to those who watched its long decline—including investors who put heat on CEO Eddie Lampert.

But contrast this failure, of a well-known chain, with the failure of financial institutions such as the 2008 collapse of Bear Stearns. When banks fail, it’s often more of a shock, even to the people with money at stake.

Chicago Booth’s Yueran Ma and Columbia’s José A. Scheinkman find that creditors monitor financial institutions less closely than they do other types of companies. Banks get less oversight, in large part because there’s no mechanism investors can use to discipline management if they need to, the researchers argue. This amounts to a significant weakness for the entire financial system.

Banks, in their simplest of forms, take in monetary deposits and lend out the funds at a profit. But modern banks also raise money from nondeposit funding sources such as capital markets, and the amounts can be substantial. At JPMorgan Chase and Bank of America, the researchers write, nondeposit sources represent 35 percent of the banks’ liabilities.

In principle, investors who have stakes in banks would watch their investments just as much as they do any others. After all, even if some standard metrics used to analyze companies don’t apply—such as EBITDA (earnings before interest, taxes, depreciation, and amortization)—there are other ways, such as capital ratios and liquidity ratios, to measure and analyze the performance of financial institutions. Yet the researchers find that investors’ oversight of financial institutions is weaker, at banks both big and small. more>

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Lurking in the shadows – the source of the next financial crisis?

By Justin Urquhart Stewart – In 2008 the collapse of Lehman Brothers was the start of the banking crisis. For those close to it, the issues had been lurking below the surface of the financial world for some time. The secondary banking crisis and the sub-prime mortgage fiasco were all in effect warning quakes for the “big one” to follow. However, even then no one really appreciated just how deep this disaster was going to be.

Other banks were supported either by shareholders or, more drastically, governments bailing them out as they teetered on the edge of collapse. For those of us watching there was fear over just how far this could go and how dangerous was the contagion of bad money poisoning good. There was also a feeling of just desserts for those arrogant and overpaid financial pseudo-aristocrats who had lorded it over their apparent domains. Not only had these people paid themselves astonishing sums of money, but then had the gall to turn to the citizens, through their governments, to bail them out, with little or no personal pain to themselves – for most at any rate. The real pain was felt by the taxpayers, the ordinary shareholders and the greater economy who bore the brunt of this.

Today’s issue is not just banking, be it commercial or investment, but rather something far more elusive – and that is the world of “shadow banking”. In essence, shadow banking is the provision of financial services but not through the usual banking outlets and companies. This may not seem to be such an issue until you consider issues such as regulation, compliance and risk management. In effect you now have new beasts on the wild financial savanna, but ones that previously you had not realized might be dangerous. Quite rightly, I will be wary of lions but don’t expect a nasty nibble from a wildebeest. more>

To Tackle Inequality, We Need to Start Talking About Where Wealth Comes From

Thatcherite narrative on wealth creation has gone unchallenged for decades.
By Laurie Macfarlane – Do people in Britain resent the rich? According to two new studies published this week, the answer to this question is: not really.

The studies, one commissioned by Trust for London and another by Tax Justice UK, explore public attitudes towards wealth based on focus groups held across England. Both found that most people are relatively content with people getting rich, and that attacks on the wealthy are often viewed negatively.

This presents a dilemma for progressives. In recent years left-wing leaders on both sides of the Atlantic have taken a more confrontational approach towards the super-rich. In Britain, the Labour Party’s war cry under the leadership of Jeremy Corbyn has been ‘For the many, not the few’, while in the US Bernie Sanders has made no secret of his contempt for billionaires.

But what if it turns out that ordinary people don’t agree? One response to this dilemma, as outlined by Sonia Sodha in the Observer, is to accept that “the belief that Britain is a meritocracy is ingrained in our collective psyche”, and adjust policies and narratives accordingly. This would mean ditching the class-war rhetoric and instead putting forward solutions designed to appeal to a meritocratic worldview. This might include, for example, closing tax loopholes and increasing particular taxes on grounds of fairness and efficiency.

Sodha is right to point out that this strategy is more likely to chime with people’s existing attitudes towards wealth. As the authors of the Tax Justice UK report note: “The participants in our focus groups largely believe in meritocracy. Those with wealth were seen as having acquired it through hard work.” Participants in the Trust for London research expressed similar views.

But does this mean that progressives should accept the way things are and move on? Not necessarily. As a well-known philosopher once said: “The philosophers have only interpreted the world in various ways; the point, however, is to change it.”

People’s views aren’t formed in a vacuum: they are shaped by social and political forces that evolve over time. Margaret Thatcher’s neoliberal revolution wasn’t just successful because it reorganized the economy – it was successful because it embedded a particular narrative about how wealth is created and distributed in society. This is a world where, so long as there is sufficient competition and free markets, every individual will receive their just rewards in relation to their true contribution to society. There is, in Milton Friedman’s famous terms, “no such thing as a free lunch”. It’s a world where businesses are the “wealth creators” who create jobs and drive innovation, and business owners are entitled to the financial rewards of success – regardless of how enormous they are.

The problem, of course, is that it bears little resemblance to how the economy actually works. While it is true that working hard will generally help you earn more money, this causality doesn’t hold in reverse: not all wealth has been attained through hard work. In practice, the distribution of wealth has little to do with contribution, and everything to do with politics and power. more>

Updates from McKinsey

The emerging resilients: Achieving ‘escape velocity’
The experience of the fast movers out of the last recession teaches leaders emerging from this one to take thoughtful actions to balance growth, margins, and optionality.
By Cindy Levy, Mihir Mysore, Kevin Sneader, and Bob Sternfels – In 2019, McKinsey asked companies to prepare for the possibility of a recession. Of course, we had no idea then that the COVID-19 pandemic would be the trigger, nor that the recession would cut as deeply as it has. But it was clear then that the foregoing growth cycle was already of unusual duration. The pace was slowing, furthermore, and the potential for shocks was greater than for renewed growth. In the same article, we discussed what top-performing companies had done in the previous downcycle, the financial crisis of 2008–09. We looked at 1,500 public companies in Europe and the United States, analyzing performance on a sector-by-sector basis. Companies in the top quintile of their peers through that crisis were dubbed the “resilients.”

Once economic and business results of the second quarter of 2020 became known, we began to hunt for the clues that were contained in nearly 1,500 earnings releases across Europe and the United States. This article seeks to understand whether the shape of the next class of resilients is visible in the data, and what lessons this would hold for companies within each sector.

The present downcycle: Six times faster than the previous one

Today, we are in the middle of the deepest recession in living memory. As pandemic-triggered lockdowns took hold around the world in early 2020, economies contracted quickly. The International Monetary Fund and World Bank foresee a global contraction in economic output in 2020 of around –5 percent; the Organization of Economic Cooperation and Development estimates an even worse result, at –7.6 percent. At any rate, the drop will far exceed the last global contraction, which was –1.7 percent in 2009.

The distress has hit all industry sectors, some harder than others. Yet even in the relatively protected sectors of healthcare, pharmaceuticals, and technology, companies are seeing moderate declines in revenue. Heavily affected sectors have experienced revenue declines of between 25 percent and 45 percent. These include transportation and tourism, automotive, and oil and gas—sectors containing some of the largest employers in Europe and the United States. more>