Letting Lehman Collapse Was Right Move

We live in interesting times...

I'm not overly surprised that the US government decided not to bail out and I think the UK government will get off lightly if Northern Rock ends up being the only UK organisation that needs bailing out.

I'm interested in why deflation is now seen as a risk given the inflationary pressures in the economy at the moment.

Hi IntoTheUnknown,

Thanks for highlighting the newsweek article. I guess it can be summed up by the statement: 'the worst lehman can do is destroy the firm.'
It's an interesting statement and I obviously hope it's true. But i'm not 100% convinced. Rapid sale of assets and unwinding of positions in derivatives isn't risk-free, surely?
OTOH, Paulson must think he can get through this without sparking financial meltdown. And if the reason is due to the 'destroy the firm' argument above, then that's great. Paulson has been able to teach Wall Street a lesson at low risk.

Ed

Hi Ed,

I too agree that deflation is a major concern. I wouldn't say it was because of "rushed asset sales", it's because credit conditions will tighten further yet, leading to a reduction in investment, consumption and confidence worldwide.

Couple this with a commodities bubble which looks to have run its course and you have a potent combination of factor adversely affecting inflation. The 1929 crash and deflation in America was prompted by a collapse in raw materials prices (Britain's woeful late 1920s performance was due to Winston Churchill's mismanagement of the level of the pound, but that's a different story!).

Inflation itself is a 20th century phenomenon: before this period, there were both periods of deflation and inflation. Inflation is really the product of a capitalist society.

Hi Monstermixer,

Yes, you're right, tightening of credit will probably be a more important factor if we have deflation. But asset prices are relevant too - and linked.

Re 'irrational exuberance': I'm not so sure. I'm 40 now, perhaps I've got 30 years to go. If you look at the 30 years prior to 2000, I don't think the mid-80s or early 70s can be seen as irrational in quite the same way as the noughties. Certainly the busts in 2001, 87 and 74 weren't as bad as this.

And I also think that the current crisis will stick in the collective memory for longer than you might expect. But yes, in the end, people will forget. It's just a question of how long that will take.

Ed

Why do you regard deflation as such a bad thing? Doesn't it depend on your situation and stage of life?

If you have income and savings then deflation means that your money goes further.

If you are retired and living on a pension then deflation means that your money goes further.

If you are a debt ridden risk taker with low net worth, then the real value of your debt will increase.

If you run a productive enterprise your costs will fall as your revenue falls, but your margin will have greater value despite being a numercially smaller amount (if that makes any sense).

So why do you regard it as a bad thing?

Richard

Sorry, I should have also said that deflation is bad for unemployment because people's wage expectations are "sticky". Irrationally, no one is willing to take a yearly wage cut. This leads to a disequilibrium in the market, next result of which is mass unemployment.

The biggest problem with deflation, as far as I can see, is the effect that it has in delaying spending.

On a personal level, why should I buy something today, when it will be cheaper in a months time? When this thought process if multiplied across the population re personal spending and also across businesses, deflation leads to a vicious cycle of stagnation as happened in Japan through the 90's.

People spend less, manufacturers therefore produce less, and as a consequence redundancies start to rise and the economy contracts. In addition capital investment becomes less attractive due to the combination of reduced activity against which to recover the expenditure as well as making the initial investment less attractive with the effect of "it will be cheaper next month". This leaves manufacturers suffering from a lack of investment once the economy starts to recover.

Once deflation has set in, it is also more difficult to control than inflation, as it is almost to use interest rates to encourage spending as you cannot lower interest rate that far from an historically low starting position.

Once the initial positive impact on increasing the amount of savings people have has been achieved, how do you encourage people and businesses back into spending? And unless they start spending again, the economy is unlikely to grow. Its why the deflationary recession in Japan took so long to work through.

If you stand back and look at the big picture the current situation has been inevitable for a long time. For 5 years or more I personally have been saying America is bankrupt, with the rest of to West not far behind (But I am just an Engineer so what would I know?). Why? because we have had a Trade Deficit with the Far East for way to long, which means all of our Wealth has been slowly transfering to China and the like. The Banks and Governments of America, England and the rest of Europe have ducked and dived to keep our standard of living going, but all based on Dept and Borrowing. People employed in Service industries rather than our traditional manufacturing base which means slowely but surley our Trade Deficit gets even worse. What we are seeing now is the bubble bursting as our way of life in the West is degraded due to us all having less money to spend. Simple evidence of this is ALL our assets are being devalued. Currency devalued - Buying power abroad becomes less. Property Devalued - Less chance to remortgage and buy all those nessesary life style items! Stocks and Shares Devalued - Less money in the market place full stop. The only good thing is as our Currency in the West is Devalued our home grown goods will be cheaper and exports should increase? My only worry is do we still have the skills to make more goods for export, and where is the investment money going to come from? Also we are talking ten years plus of pain before things improve if we are lucky.

Ed, if you can say "I may not see ‘irrational exuberance’ again in my lifetime" you must be very old. Over the last twenty five years we have seen Latin American Debt, junk bonds, the .com bubble, UK house price boom and bust twice... shall i go on. That's a pretty regular sprinkling of "Irrational Exuberance" on average about once every five years. For your sake I hope you live to see the next one:))

Anatole Kaletsky, the economics commentator at The Times, said some interesting things on Newsnight last night. He was concerned that despite the US Treasury Secretary, Hank Paulson, being an avid student of the Great Depression, there is a risk that he and/or his political masters, anxious to look populist in an election year, may end up repeating the mistakes of Andrew Mellon in 1929-30. According to Kaletsky, Mellon had a policy of allowing major banks like the Bank of the United States to fail, as a warning to the rest to sort themselves out - he took the view that capitalism should be allowed to do its work without government intervention. Unfortunately this completely destroyed confidence and led to a cascading series of failures, businesses couldn't raise finance, and the wider economy, already in a downtown, just went from bad to worse. A hairshirt policy of letting everything fail in order to encourage the others risks the same result now, so the best solution seems to be a combination of takeovers, government support, some failures, and re-regulation. Of course no-one has a crystal ball here, so there will be some cock-ups, but to say "always let banks fail, don't let taxpayers get involved" is a really bad idea given the historical precedents and, I'd argue, plain common sense that recognises that central banks have to be the lender of last resort, and act like it.

Deflation is bad because it destroys businesses and peoples lives. It does not matter how hard you work you cannot make a profit result mass unemployment, riots and eventually war, the second world war was a direct result of the 30's depression.

I have been in financial services for 35 years I have lived overseas and have travelled extensivly
Meltdown is a mild word for what we are seeing in the financial markets We are for It big time
I have lived through 4 recessions in england and abroad but never a depression which I am pretty sure this is going to be .
I am usually a very posistive person however this is going to be somthing most of us have never seen or lived through before before.

Our government CAN do somthing for Britain our problem is NOT entirely caused by global problems however I do not think they could come up with an idea between the lot of them.

Gordon Brown should start taking advice from experts not the hairy fairy sicofants surrounding him, who have never had a proper job in industry or business in there entire lives.
So much money has been wasted in this country that we have no room for manouver

Elaine

Matchmade commented "A hairshirt policy of letting everything fail in order to encourage the others risks the same result now, so the best solution seems to be a combination of takeovers, government support, some failures, and re-regulation."

Agreed - the key element here is that there needs to be some failures that are not prevented by Government action. For the Government to always rescue failing organisations leads to a culture in which excessive risk taking remains unchecked, while never preventing failure can cause a collapse in confidence that makes the current problems worse.

The implications of failure must remain apparent (and real) to private businesses, while the Governments should act only to protect the wider economy from a major crisis.

This is not just a failure of business, but also one of regulation in which central banks and financial regulators have been complicit over the past 2 decades.

The American say that they have an antiquated Financial services regulator

Britain is supposed to have a state of the art service regulator the FSA .yeah right !

Where were they when the British banks were buying toxic packaged mortgage debt from America ?
Ticking their boxes no doubt
FSA not fit for purpose springs to mind

"Too big to fail" seems like a recurring theme here. The institutions may well be, but the people who work there aren't - even the O'Neils, Princes and Thains of this world. The banks (as institutions) wouldn't behave as irresponsibly as they do if the bankers (the people who work there and make decisions) had more to lose when the banks (insitutions) screwed up. Even if the banks (institutions) are allowed to fail, the bankers (people) who caused the behaviour that caused the institutional failure will get to keep the bonuses they got paid for engaging in or sanctioning that behaviour. Until these personal bonuses are reversible, or perhaps paid against performance averaged over longer periods I expect that significant, lasting institutional learning will not occur. And let's not pretend that being redundant for a year or two is tantamount to having the last five years' bonuses taken back, cos it isn't.
The nearest thing to light at the end of this tunnel is that the people who own shares in these institutions also stand to "have their bonuses taken back" (many of them have already lost a great deal, some of them have lost more than they ever made from owning these shares) and perhaps those who own bank shares in future will remember that. And perhaps they will exercise enough control over the managements to whom they hand most of their powers as owners to make sure that "we don't get fooled again".

hello everyone,

Re my comment on 'irrational exuberance.' I wish I had phrased that differently. Sure, individual markets will overshoot at various points to come in my lifetime. At some points, some markets will overshoot in combination.

But I'm not sure that we'll see quite such a crazy period as the last few years in the rest of my lifetime. A crazy period where people assumed it was easy to make money. All you had to do was borrow some money, buy an asset, and watch the profits come in.

We may not see such an exuberant period during the next 30 years, but I could be wrong.

Ed

Of course we already have deflation in one area - the housing market. How many people (like me) are sitting in rented accommodation waiting for the price of houses to fall? And how many potential sellers are refraining from putting their houses on the market until the market picks up. Result: market slowdown, lay-offs in estate agents and building firms. This is just by way of illustration.

db

I keep hearing a lot of statements such as "The good old index-tracker fund will do nicely", could someone please explain in a little more detail why?
I would like to invest long term in some type of shares if this really is a good time to invest but before I go and make a mess of it, I would like to get as much advice as possible, any tips of how, where and what to invest in would be great also?

And Im really only planning to drip feed money into them such as 50 pounds a month and hoping over time with some luck I will get a greater return then just lumping them into savings accounts?

Thanks again,
Irfan.