DABERIAM XXXVI

December 2007

It is unusual for me to put pen to paper twice within four weeks but having just re-read the Daberiam of December ’06, when I observed that ’07 would probably be as benign as ’06, with clouds gathering in ’08 - the storm arrived a little early! 

The storm raises some real concerns about the ability of Central Banks to cope with the complexity and linkages in the global economy. The world’s economy today is much more akin to weather system and the famous butterfly effect. This makes the individual economic models that Central Banks use dangerous. Bankers that over-indulge in models use them as a substitute for thinking, time is spent arguing about modifying the model rather than looking at the events that are unravelling in a complex world. 

In the last few months, the Fed has misjudged the severity of the financial crisis and still appears to be looking at it as a liquidity problem rather than a credit crisis. The unravelling of the structured debt market is causing downward pressure on asset prices that have been inflated by the expansion of credit. This downward pressure itself is causing more of the structured debt to be downgraded. Many of the financial institutions that hold this paper do not understand how the structures work and how the ratings work. Indeed I believe there are many bank directors who don’t understand either. The asset price inflation that has been driven by the creation of these vehicles will now become deflation. Banks do not trust each other and are still not even sure what they have in their own engine rooms, unravelling this problem will last certainly through the first quarter of next year.

Global Economic Indicators

World Economic Growth  (World Bank figures)	2006	4.00%	2005	3.60%	2004	3.40%
Base rates: 18 Dec 2007	USD	4.25%	EUR	4.00%	GBP	5.50%
MSCI World Equity Index	30/11/2007	284.33	29/12/2006	235.243	YTD %	20.87%
Gold (PM London Fix $ per ounce)	30/11/2007	783.50	29/12/2006	635.70	YTD %	23.25%
Oil (WTI Crude $ per barrel)	30/11/2007	88.72	29/12/2006	61.06	YTD %	45.30%

Compare this with Société Generale where the failure in an enormously complex area of the bank has caused a public outcry and the pillorying of the management from the Chairman downwards, and set off a raft of investigations by the regulatory authorities from New York, through London and back to Paris. No public money has been lost or public rescue been mounted; while the events appear to have generated a loss of some $5 billion or so, this is sustainable and now under control. 

The difference between the two seems to be that one was an abject failure of the establishment system; the other was an internal failure of controls in an immensely complex part of the bank’s operations. While Governments, Regulators and the Press have had a field day pillorying Société Generale Chairman Daniel Bouton, an enormously sophisticated and successful banker who has built an immensely impressive company, he has handled the crisis in his organisation impeccably with great speed and efficiency; the handling of Northern Rock has been a complete shambles in virtually every aspect. 

On a different tack, it is worth observing in the context of the present economic crisis that we are probably nearing the bottom of the cycle. The world and his dog now knows there is a financial crisis and the unanimity of downward pointing forecasts indicates the turn is not too far away. We still have to get through the publication of the history of 2007 in the form of year-end accounts. Every Chief Financial Officer and auditor will be throwing the kitchen sink into the last few months of the year so as to have some hidden reserves to go into 2008. Clearly there is always a risk of systemic failure but it is now less likely than it was a month or two ago. 

The US Government, in an unusual and highly impressive flash of unanimity, has created a financial stimulus to the US economy that will add a good 1% to the GDP of America in the second half of the year. The Fed has acted dramatically and impressively to address the situation. The Sovereign Funds of the Middle East and China are moving in an impressive fashion to take advantage of the confusion in the West, buying discounted assets, so putting liquidity back into the system. 

The not-so-bad news is that markets will continue to be volatile and could continue to go down for a while, but the really bad news is that inflation rather than deflation is going to be the order of the day going forward. 

The extraordinary phenomenon of Chinese industrialisation is slowing, but the price of its exports is rising along with the value of its currency, pushing up prices in the West. Oil in particular, and energy in general, will continue to rise in price as the political systems of the West continue to fail to address the energy needs of their economies as they are fearful of the green movements. 

Unfortunately, the slow down needed to unravel the huge pile up of Government and private debt that has created a large part of the economic growth of the last few years will not push down inflation as it has done in the past because of the growing demands and successful management of the Chinese, Indian and other rapidly developing economies. 2008 will be “interesting times” but by the end we will be entering into a new world order, with China, India and Russia becoming clearly major players on the world stage. The “West” will have to be more conciliatory.

Damon de Laszlo 
December 2007