World Economic Forum

Global leaders see confidence crumbling

‘We have to pay for the sins of the past’ – founder of World Economic Forum.

John Fraher and Simon Kennedy, Bloomberg
22 January 2008 00:00

Jean-Claude Trichet and Lawrence Summers accurately warned investors a year ago about being too complacent. Now they see an erosion of confidence that threatens to paralyze the global economy.

Former US Treasury Secretary Summers returns to the World Economic Forum in Davos, Switzerland, this week urging quick action in the form of economic stimulus to head off "a cascading loss of confidence" in the US economy after the collapse of its housing market. European Central Bank President Trichet, also travelling to the Alpine retreat, is leading international colleagues in lending emergency cash to banks.

"When you have recessions from bubbles bursting, they tend to be protracted," says Summers, a Harvard economist and the university's former president. "There is the possibility, not yet at all the probability, that a recession could prove long and severe."

As the hubris that Trichet and Summers decried last year is replaced by fear, an aversion to risk-taking may worsen the outlook for the world economy.

"Davos was marked last year by an irrational exuberance," Josef Ackermann, CEO of Frankfurt-based Deutsche Bank AG, Germany's largest bank, said in response to a question. "I hope that we don't swing to the opposite this year and give in to an irrational depression."

Bankers are dumping derivatives that drove the credit boom in favour of havens such as gold and US Treasuries. At the same time, they're constraining lending and eliminating jobs.

In the past 10 days, Citigroup Inc cut 4 200 positions after its biggest quarterly loss ever, German investor confidence fell to the lowest level since 1992 and the first signs emerged that China's economy may be slowing.

"We have to pay for the sins of the past," Klaus Schwab the World Economic Forum's founder and chairman, said in a January 11 interview. "The mood of Davos has changed."

"I don't know how you can have an optimistic, self-congratulatory feeling today," says Stephen Schwarzman, co-founder of Blackstone LP, the world's largest buyout firm.

People nursing losses as they try to enjoy the Davos party circuit can't say they weren't warned. Trichet said at the 2007 forum that a "reappreciation of risk" was "likely". Summers compared the confident mood then with the market sentiment that prevailed just before World War I.

The Jeremiahs of a year ago are now preaching policies to limit the damage they foresaw. Summers was one of the first economists to propose remedies such as tax rebates and extended jobless benefits to avert recession in the US.

Among central bankers, Trichet, has led the way in offering emergency funds to financial institutions stung by the jump in credit costs. The measures culminated in the broadest instance of international economic cooperation since the aftermath of the 2001 terrorist attacks, as the Fed, the ECB and central banks in Canada, the UK and Switzerland made cash available to commercial banks to keep markets functioning.

"Risks are on the downside," Trichet said in Basel, Switzerland, on January 7, pointing to "the impact of the significant market correction".

Still, the financial crisis may turn out to be one of the worst ever, concludes a new paper co-written by Davos speaker Kenneth Rogoff of Harvard, the former chief economist at the International Monetary Fund, and Carmen Reinhart of the University of Maryland. Their review of 18 previous slumps found that, on average, financial crises knock 2 percentage points off growth and recovery requires two years. The worst episodes cost 5 percentage points of growth.

"The big question is how deep the losses in the banking sector will be," Rogoff said in a January 15 interview. "They will be at least $300bn to $400bn, which would be a moderate crisis. But if house prices continue to drop, we could see two or three times those losses, and it will one of the bigger financial crises."

Nouriel Roubini, founder of New York-based Roubini Global Economics LLC, calculates losses will top $1trn. "The risk of a systemic financial crisis is rising," says Roubini, who spent last year's conference warning of a US recession.

For top executives and investors, the danger may be that the mood becomes so dark they talk themselves into recession.

"We tend to be overly optimistic when times are good and overly pessimistic when things go sour," says John Snow, chairman of Cerberus Capital Management LP, another former US Treasury secretary and a Davos delegate. "It has all the makings of a tough year."