There’s something truly scary about the current financial crisis and the potential risks to the global economy when the International Monetary Fund warns that governments need to "think the unthinkable."
This is a sign that we are in uncharted waters and even the top experts don’t know what will happen next. The IMF is saying that despite recent massive interventions in financial markets by the U.S. Federal Reserve, the Bank of Canada and the Bank of England, things could get much worse.
Indeed, we could be headed for the worst financial crisis since the 1929 stock market crash and the Great Depression of the 1930s.
The decline in the value of the U.S. dollar, a U.S. recession that’s already here, a credit crunch making loans more difficult to get, and rising interest rates for businesses and homeowners are among the factors already at work since the subprime mortgage crisis emerged last August.
Failure to restore confidence in the financial system would make all of these factors worse. Governments could even be forced, in a massive bailout, to take over the bad investments made by banks. Losses by financial institutions from the subprime mortgage crisis have been estimated at $500 billion to more than $1 trillion.
Moreover, Goldman Sachs warns U.S. housing prices could fall 25 per cent from their peak and wipe out $5 trillion of wealth in American households. For many this would wipe out all of their home equity and even leave them owing more than their houses are worth. There are fears of a similar drop in prices in commercial real estate. In addition, the sharp fall in the stock market has wiped out considerable wealth.
And it’s not over yet.
"The need to prepare systematically for potential risks has been demonstrated amply during the past few months," the IMF’s John Lipsky has warned. "After all, the failure of both financial institutions and public authorities to anticipate the current challenges already damaged some core institutions, undermining confidence and weakening economic prospects."
One risk that Lipsky highlighted is the emergence of "a global financial decelerator" where the financial crisis could do even more damage to the underlying economy, affecting jobs and growth fast cash. In this scenario, rising defaults or margin calls could force the fire sale of assets by borrowers unable to come up with cash to meet the demands of their bankers.
These forced sales would push down the value of office buildings, businesses and other assets, leading to a further deterioration in the value of remaining collateral assets and a new round of defaults or margin calls.
The result would be asset-price deflation, a downward credit spiral and a deep recession. A growing number of hedge funds are already getting margin calls, selling assets at low prices or going into default.
The U.S. Federal Reserve has made two interventions of $200 billion each in recent days to support financial markets while the U.S. government is injecting $168 billion of tax rebates to American households in the hope they will spend. There’s little evidence these kinds of actions are working so far.
Bank of Canada Governor Mark Carney has pointed out that "the end is not yet in sight," adding that "some of the world’s largest financial institutions have recorded substantial losses, the cost of borrowing has increased, and the availability of credit has decreased."
Not surprisingly, "our economy is beginning to feel the effects of the deterioration in global financial conditions."
The failure so far to restore confidence in financial markets, with oil prices hovering around $110 (U.S.) a barrel and gold in the $1,000-an-ounce range as investors rush for safety, show why we should worry. The IMF’s warning is spot on.
David Crane can be reached at crane@interlog.com.
Source