An American Sneeze; A Chinese Cough

By Mo Fakhro

How can we prepare for the next global economic crisis? Where will it come from? How will we emerge from it? The financial crisis of 2008, was a lesson for the world about the risks of providing too much liquidity to the system, and the risks of too much deregulation.  It also showed us how effective intervention by the Federal Reserve and Federal Government in the United States, helped to prevent a second great depression.  While the coronavirus pandemic has shown us again how effective action by the Federal Reserve can lessen the impact of a major global crisis, it is important to also be aware of the risks that the current additional liquidity poses to the system, and to make sure an environment is not created that is similar to the one created during the years preceding the global financial crisis.

It is important for the global economy to not repeat the mistakes of the past.  One of the initial triggers of the financial crisis was the increases in liquidity during the years leading up to the crisis (2).  This was driven by the need to maintain economic growth, and by the US government’s need to offer housing to a larger portion of the population.  However, it led inadvertently to an asset bubble in the housing sector and to speculation.  The additional liquidity created by providing additional resources to Freddy Mac and Fannie Mae to buy mortgage-backed securities, led, perhaps inadvertently, to a rush to give mortgages to, in effect, anyone who would be interested to take them.  This led to a loosening of controls on who could get a loan.  The low principal payments, and the delays in the payment of initial installments, also created a speculative situation where people would purchase a property through a bank loan, not to use that property or rent it, but just to hold on to it for a few months before selling it.  Greed ultimately got the better of the system.  Individuals and financial institutions realized too late that they had overextended themselves, and the crash that followed led to a great deal of hardship around the world.

While deregulation of the financial system had many benefits, one of its drawbacks is that it led to the creation of very large financial institutions that became too big to fail.  When the McFadden Act was repealed beginning in 1994, it set off a chain reaction that led to a wave of mergers and acquisitions in the financial services sector.  The benefits of mergers from a business standpoint due to economies of scale and loan diversification, led to the size of banks growing and the number of banks reducing.  This led to a situation around the financial crisis where a number of financial institutions had become too big to fail.  They were thus emboldened to take on excessive risks, and their creditors became comfortable with excessive risks, due to the implicit assumption that if things did not work out, the government would have no choice but to bail them out.

Deregulation in the form of the effective repeal of the Glass-Steagall Act in 1999, also removed the rigid lines that separated retail banking from investment banking.  The benefits of economies of scope thus began to take hold, and led to the creation of financial institutions that accepted deposits but also operated hedge fund divisions.  The same financial institution that was entrusted with people’s savings, was also allowed to provide insurance against the default of mortgage-backed securities.  This added to the sense of uncertainty during the financial crisis, because it was not clear what the impact of the crisis was having on the megabanks of the time, and it was not clear which of them would need a bail out or would even get a bail out.

The financial institutions that had offered insurance against the default of mortgage-backed securities found themselves in a particularly difficult position.  These instruments, named credit default swaps, became a serious issue when the market crashed.  Many large financial institutions, including AIG, found themselves holding huge liabilities because they had provided other firms with insurance against default of their mortgage-backed securities.  These firms ultimately could not survive on their own.  Some had to close down while others needed to be merged, acquired, or bailed out (5).

The overall end result of the financial crisis was that US Government debt increased from approximately 8.5 Trillion US Dollars in 2006, before the financial crisis, to 19.5 Trillion US Dollars by 2016, just ten years later (3).  Furthermore, a 2011 report by the United Nations found that the number of unemployed people around the world by 2009 was 27 million more than it was in 2007 (4).  As bad as the result of the crisis was though, it would have been significantly worse if governments and central banks around the world had not acted quickly to resolve the turmoil that ensued as financial institutions began to default on their obligations.

One of the consequences of the financial crisis has been that it has harmed to reputation of Wall Street banks, and led to a mistrust of the financial system by the general public.  The percentage of people who generally distrust banks increased from 13% in 2007 to over 30% by 2011 (6).   Wall Street financial institutions have come to be seen in a more negative light as a result of the financial crisis.  The high salaries of bankers, and the high value of the bail outs that will ultimately be paid by tax payers, has left a bitter taste in the mouths of people.

The speculative bubble in real estate before the financial crisis, has similarities to the current situation in the US stock market.  The wild speculation in the price of stocks like GameStop, a US games retailer with questionable business prospects, indicate that the market may be driven increasingly by speculators.  The speculators increasingly appear to be buying shares not because they believe in the underlying value of the assets that they are buying, but because they simply are interested in day trading.  Robinhood, a trading app that is popular with millennials, has seen rapid growth in volumes recently (7).  The increased liquidity to the real estate sector before the financial crisis was well intentioned, but it inadvertently led to a crash.  The increased liquidity to the banking sector currently is similarly well intentioned.   It is important to make sure that it does not lead to a similarly calamitous outcome in the future if the market turns. 

The similarities between the years preceding the financial crisis and the current situation of excess liquidity in the financial system, do not end there.  As financial institutions aimed to increase their return on assets and return on equity, many increased their leverage.  When the crash came, those that were exposed had to take write offs on the value of the real estate loans that they had given out or on the value of the real estate on their books, or the value of the mortgage-backed securities on their books.  While the Federal Reserve acted very well to prevent a serious economic crisis during the coronavirus pandemic, some have argued that it may now be providing too much liquidity to financial institutions (1), and thus leading to the same increases in leverage that exposed financial institutions during the years preceding the financial crisis.  When banks receive too much in deposits, this puts pressure on them to lend those funds out.  With a constant equity base, this would have the effect of increasing the debt-to-equity ratios of banks and thus increasing their leverage.

As we move into a post pandemic world, it is important to recognize the vulnerability of the global economy, and the critical role of the Federal Reserve.  While it is clear that the Fed played a key role in providing stability by adding liquidity to the system when the pandemic first hit, it is now a cause for concern amongst many that there is too much liquidity in the financial system.  A recent article in the Economist (1) highlighted this added liquidity as a cause for concern.  It mentioned that banks have so much liquidity that they are now driven to turn away depositors.  The Federal Reserve has been buying approximately 150 Billion US Dollars in new bonds every month.  As these dollars get deposited by the sellers of the bonds into banks, the money multiplier begins to take effect.  The banks that receive the funds then lend most of them out to people or companies who deposit them in other banks, and so on.

The implications of this could be that there is an excess in liquidity in the system.  Excess liquidity could have harmful effects on an economy.  It may lead to an inflation in asset values.  With most manufacturing done in low-cost areas around the world, it could be that the impact of excess liquidity of consumer prices will not be felt.  For example, an excess in liquidity that drives rents higher in the US, will not necessarily raise the prices of consumer goods because the factory in China pays employees’ salaries who do not get impacted by the higher rentals in the US, and hence do not ask for raises.  Another factor that may be preventing an increase in consumer prices is that retail has been impacted by the shift online, and so commercial rentals would tend to decline in such an environment, thereby preventing a rise in costs to retailers, and preventing the need to correspondingly increase prices.  While consumer price inflation seems to be under control, that does not seem to be the case with asset prices.  The increase in liquidity has been one of the factors that has driven up the price of stocks and bonds.  This has led to an asset bubble that may ultimately burst in a way similar to what happened to real estate prices during the financial crisis. 

It used to be said that when America sneezes, the world catches a cold.  This became a common phrase after the Cold War left the United States as the dominant economy of the world.  It greatly simplified the management of the global economy, because it implied that to avoid getting sick, the world had to just prevent America from getting sick, and to prevent America from getting sick, the Federal Reserve needed to simply act prudently and effectively to respond to economic turmoil.  With the emergence of the European Union as an economic block and, in particular, of China and India as significant global economies, it sometimes feels as though we are moving from a unipolar global economy dominated by the United States to a multipolar global economy with no clearly dominant force.  However, as the coronavirus has shown us, our globe is more interconnected than ever.  A crisis somewhere could easily spread to a crisis everywhere.  While we are no longer burdened by global borders, we are also no longer protected by them.  During the global financial crisis, America sneezed and the world caught a cold.  With the coronavirus crisis, a cough in China led to the death of millions of people, and to a shutdown of the global economy.  Earlier this week, a single ship clogged an artery at the heart of global trade in the Suez, bringing the exchange of goods across large parts of the globe to a standstill.  Where will the next crisis come from? How will we prepare for it? How will we respond to it? It will increasingly require the coordination of global institutions and cooperation between the governments of the world.  The maintenance of open and cordial communication between governments is critical to achieving this, not only for global peace, but increasingly too for global prosperity.

Paper: US Monetary Policy During Corona

By Mo Fakhro

The Federal Reserve acted quickly and effectively to reduce the negative economic impact of the coronavirus pandemic, and helped to alleviate a great deal of financial suffering.  It did this through a combination of lowering the federal funds rate (the rate at which banks lend to one another), directly buying Mortgage-Backed Securities to lower long term interest rates, providing additional liquidity to stabilize markets, and directly supporting small and medium sized businesses with loans.  The expansionary monetary policy of the Federal Reserve was not the only major policy of the US Government.  It was also coupled with an expansionary fiscal policy, that was headed by the US Treasury and US Congress.  The quick actions of the Fed compared to Congress, demonstrated the usefulness of the Fed as a relatively unbiased, independent entity, that can act quickly.  While the actions of the Federal Reserve were much needed, and had a positive net impact, they helped to contribute to what some perceive as an asset bubble in the stock market, that could have future negative consequences.  They also may have had the net result of providing too much credit to uncreditworthy companies, which may lead to an increase in defaults in the future.

Among the actions that the Federal Reserve took when the pandemic started to take its toll on the US economy was to lower the Federal Funds rate to almost zero (1).  The Federal Funds rate, despite its unusual name, refers to the rate at which banks borrow from one another.  In some countries it is referred to as the interbank lending rate.  The Federal Reserve influences this rate by increasing or decreasing the money supply.  It typically does this through what are referred to as open market operations, which involves either the purchase of government bonds onto its balance sheet, or the sale of government bonds.  An expansionary monetary policy involves the purchase of government bonds.  This has the effect of increasing the money supply, because it puts money into the hands of the sellers of the bonds.  This in turn reduces the Federal Funds rate, which in turn reduces the cost of borrowing across the economy.  As more money becomes available to banks, and as they rush to lend out those funds to their customers, this increase in the supply of money will cause the interest rate across many parts of the banking system to drop.

Between March and June of 2020, the Fed significantly increased its purchases of US Treasury Securities and Mortgage-Backed Securities.  According to the Board of Governors of the Federal Reserve System, the Fed’s holdings of securities increased from around 4 Trillion US Dollars to 7 Trillion US Dollars (1).  These additional holdings of securities had the effect of adding an additional 3 Trillion US Dollars of cash into the system.  When the effects of the money multiplier are included, the additional dollars in the system that were deposited into banks were amplified by upto ten times.  This would have provided banks with additional deposits and reserves, which would have put pressure on them to lend out the new funds to businesses.  As a result, businesses would have been better able to attain loans from banks.  This in fact appears to have been the case.  The actions of the Fed to purchase securities had the additional benefit of stabilizing the markets during a critical period of uncertainty.  This helped to reduce volatility in the markets, which would have created a sense of panic, that may have had a ripple effect to other parts of the economy.  The quick actions of the Fed ensured that markets flowed smoothly by providing liquidity (2)

In addition to this, a lending program was launched to support businesses, called the Mainstreet Lending Program (2).  This program allows loans to be given to small and medium sized organizations, in order to help them to meet their working capital obligations.  It was coupled with another program named the Payroll Protection Program, which, as the name suggests, protected employee wages, thereby reducing the need to lay people off.  These two programs require the approval of the US treasury, and are referred to as “13(3)” actions because they are derived from that part of the laws that govern the Federal Reserve.  The Fed also took the step of directly buying the bonds of companies, as well as buying shares in exchange traded funds that focus on corporate bonds (2).  This had the effect of increasing the liquidity for bonds and reducing the interest rate. This program of quantitative easing, allowed the Fed to ensure the free flow of funds, and further ensured that the increases in money supply made their way across the economy. 

The additional liquidity has provided a lifeline to companies during a very challenging period.  The overall impact of these measures by the Federal Reserve has helped to ensure that liquidity is available for companies to borrow money at low interest rates.  It has thus allowed companies of different sizes to remain afloat during a period of severe negative cash flows in certain segments.  The additional supply of money though, does bring with it the risk of artificially inflating the value of assets and instigating future loan defaults.  Some have drawn attention to the fact that, while the expansionary monetary policy of the Federal Reserve during the coronavirus pandemic did not cause significant consumer price inflation, it does appear to have caused asset price inflation (3).  They further argue that the Fed measure of inflation should include asset inflation, not just consumer price inflation.  By that measure it is noteworthy, that prices have in fact inflated in areas such as housing and publicly traded shares during periods of expansionary monetary policy.  Others have noted that even sectors with a bad credit history, such as airlines, have an abundance of credit available today (4).  While this is desirable from an economic and social perspective, because it supports vital infrastructure, it does highlight the risk that cheap and abundant credit may lead to loans being given to entities that may have trouble paying them back.  The airline industry has historically not been a good sector for lending.  This is because of high levels of competition, and the cyclical nature of revenue (seasonal travel), coupled with high fixed costs (the planes), and unpredictable and often erratic variable costs (fuel prices), have meant that loan defaults in the sector have tended to be high.

The actions of the Federal Reserve were not the only economic stimulus conducted by the US Government.  The expansionary monetary policy was coupled with an expansionary fiscal policy that was conducted by the US Treasury and US Congress.  While both had varying impacts, the monetary policy of the Federal Reserve was far quicker and demonstrated the need for an independent entity that can take quick and effective action in the absence of politics.  The delays in fiscal policy approvals by the US Congress further reiterate the need for an entity like the Federal Reserve to stabilize markets quickly and independently, particularly during times of economic crisis.

It is difficult to imagine what would have happened if the Federal Reserve did not exist.  During past crises prior to the creation of the Federal Reserve, the government would have been unable to react the way that it had in response to the coronavirus pandemic, to prevent a financial or general economic crisis.  Time will tell what the net impact of the actions of the Fed will be.  While its actions stabilized the market during a critical time, they also provided a great deal of liquidity, that may have artificially inflated asset prices, in a way that may lead to significant future corrections in the months and years to come.  It does appear, so far, that what the Fed has done in response to the coronavirus has worked, but ominous signs hang in the balance.

Paper: The Luckiest Family in Jerusalem

By Mo Fakhro

There was once a family in Jerusalem that had all the luck.  For they were a family of pigs.  The only family of pigs in all of Jerusalem.  The Israelis were always afraid of being killed by the Palestinians.  The Palestinians were always afraid of being killed by the Israelis.  The goats, cows, and chickens lived in constant fear of being eaten by both the Israelis and the Palestinians.  So too was the plight of the fish in the sea. The small fish afraid of being eaten by the big fish, and the big fish afraid of being eaten by the Israelis, the Palestinians, and the occasional sea gull.  Everyone lived in constant fear of being killed, except for this lucky family of pigs.  They were shunned by the Jews and the Muslims, who had been told by God that they could not eat them, and so, they roamed the lands freely without a care in the world. 

This is a fictional story that I have just made up to illustrate a point.  The point being that luck is determined to a great extent by the accident of where and when you are born.  If this family of pigs had been born two thousand years before, a miniscule amount of time in the history of the world, they would have been eaten by humans.  If they had been born a few hundred miles to the West, in Europe, they would have been slaughtered and converted to bacon.  Survival in this world for this family of pigs, will have been determined by the accident of when and where they were born. 

We are all lucky to be alive if you really think about it.  It is a complete miracle that each of us is alive today.  We have to be the lucky one out of millions and millions of sperm cells that makes the treacherous journey into its egg.  To add to that, our parents need to have met, and our grandparents, and our great grandparents, an almost infinitely high number of coincidences, just so that we could be here today.  It is clear that luck plays an important role in our lives, since we are all so lucky just to be alive.

Is it then surprising that success in the stock market is determined by luck?  Or that successful entrepreneurs are lucky? Is Bill Gates smart for creating Microsoft or lucky? What about Jeff Bezos or Elon Musk? What about Warren Buffett or Peter Lynch? They are surely smart.  No one can realistically doubt that.  But how much of their success is based on luck and how much of it is based on smarts? I would argue that their success is primarily due to luck.  To begin with, they are lucky to be alive for the same reasons I mentioned earlier, just as we all are.  Furthermore, if they had been born 2000 years ago, they may not have excelled at hunting for animals the way that they excelled at writing software or finding value on the stock market.  If they had been born a few thousand miles to the east, in Africa, they may not have excelled at corruption or warfare, the way that they did at more intellectual pursuits.  Elon Musk was born in Africa, but we all know he is not really a human anyway.

What determines success on the stock market, and what role does luck play in that? It is a question that has baffled economists for decades.  The Efficient Market Hypothesis, on which much of classical financial thinking is based, implies that it is impossible to consistently “beat the market”, because markets are perfectly efficient.  What this means is that all available information about a stock is priced into it, and that any opportunities are immediately eradicated by arbitrage.  In recent years, a new branch of finance has emerged named Behavioral Finance.  In this branch it is assumed that humans are driven not only by rationality but also by emotions.  They tend to get overly cautions when they lose money and overly confident when they make money, in a way that impacts the rationality of their subsequent financial decisions.  It also assumes that investors are influenced by their own biases and are thus not perfectly rational in their thinking.  Using the pigs’ analogy, if we took the family of pigs on a boat from Jerusalem to London, they would still roam freely without a fear in the world, until they invariably will have come across a restaurant serving pork chops. 

Do the current investors in the stock market resemble the pigs that got transported to London? Could it be that they are too young to remember the 2000 crash, or the 1987 crash? Are they too optimistic because they have never seen blood on the streets? Is a crash on the way that will turn their Robinhood portfolios to pork chops? Is the market driven now by irrational exuberance, as it was during the late 1990s? Of course, the truth is that only time will tell.  We are living through unusual times that may lead to consequences that are difficult to predict. 

Blog: Food for Thought

By Mo Fakhro

The coronavirus pandemic has created a great deal of hardship for people across the world. The primary negative effect has been on the people who have been directly impacted by the virus. This includes the millions of people who have been infected, those who have become seriously ill, those who have died, and the loved ones who have seen the impact of the pandemic on their households.

While I acknowledge their hardship, I write here to address a hardship of a different kind. I write here to address the livelihoods of the people who have been financially affected by this virus. The people who have lost their jobs, those whose businesses have suffered, and others whose income has been otherwise affected.

More specifically as it relates to Bahrain, I write to address the impact on the livelihoods of restaurants in Bahrain, by the closures relating to the coronavirus pandemic. While the health tragedy of the pandemic is clear, I write here to address the opportunity to minimize the economic impact of the pandemic, by prioritizing activity that results in economic transactions, particularly economic transactions that have a high multiplier component.

In economics, every time that a transaction is made, a contribution is made towards GDP. This can be a transaction of any kind. It is especially true in the case of the restaurant sector, because of the multiplier effect of an industry that largely buys products and services locally.

This simple fact means that the utilization of a free service, such as going to the beach, visiting a place of worship, visiting a public pool, or meeting friends and extended family at their homes, does not directly impact GDP and does not contribute to economic growth, even though they all contribute to the spread of the coronavirus. In parallel, a number of other activities, such as going out to a restaurant, contribute to GDP while contributing (but I would argue to a lesser extent) to the spread of the conoravirus. The question that then needs to be addressed, is what can we do to minimize the economic cost of the pandemic, while also minimizing its spread.

I am not a doctor and so I could not make a medical case for my point of view. However, I do oversee the operations of restaurants across the Gulf. In Saudi Arabia and Kuwait, the restaurants sector has reopened and sales have improved. While the pandemic is still present in both countries, the opening up of the restaurants sector does not seem to have led to a significant increase in cases to the best of my knowledge. While this is not a scientific assessment, it is a point worth noting. The reopening of restaurants in both countries has however helped to revive their economies by allowing for transactions to restart.

Unfortunately, the coronavirus pandemic has hit Bahrain’s tourism industry very badly. The industry is in urgent need for a reopening to avoid detrimental long term damage, particularly the restaurants segment. This has come at a critical time, when the country’s natural resources are running out, and its debt levels have risen substantially.

The country’s tourism industry represents a significant opportunity over the long term for tax revenues to pay down debt levels, and to increase foreign exchange reserves from tourists. The current closures of tourism facilities over the past six months have put the entire industry at risk. I would not be surprised if we begin to see mass and permanent closures of restaurants facilities if the current trends continue. This will have the unfortunate effect of reducing the product offering to tourists who decide to come to Bahrain for their weekends or extended breaks.

It will also likely reduce future investment in the sector, as companies deplete their reserves to survive the pandemic. This is the harsh reality that we now face as a country. It is a Sophie’s choice of sorts, between the survival of a crucial industry of the country and the need to ensure the health and wellbeing of a nation.

While the risks of opening the restaurant sector are present, I would argue that opening up restaurants to increase their revenues and prevent their closures will not have a significant impact on the trajectory or case numbers. It would also provide a vital lifeline to a sector that has become known regionally for its vitality and vibrancy, and has come to represent a key driver of tourism to the country.