Four ways to prepare for a global financial crisis

Central bankers seem to be increasingly worried about the risks of global financial catastrophe even though they are primarily responsible for creating the conditions that could produce such a disaster!

Their own "club," the Basel-based Bank for International Settlements (BIS), warns ominously in its latest annual report that the world economy could experience a massive shock, as it has in the past.

"The Great Inflation in the 1970s took most commentators and policymakers completely by surprise, as did the pace of disinflation and the subsequent economic recovery after the problem was effectively confronted.

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"Similarly, virtually no one foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast Asia in the early and late 1990s."

The BIS makes this interesting point: "Each downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a new era' had arrived." Just like now!

"We face a fundamentally uncertain world," says the BIS, where it's impossible to assign probabilities to the risks that are faced. The collapse of the huge and highly-respected New York hedge fund LTCM in 1998 was triggered by "price shocks almost ten times larger than might reasonably have been expected based on previous history.

"As a result, its fundamental assumptions that it was adequately diversified, had ample liquidity and was well capitalized all proved disastrously wrong."

The experts are now generally optimistic about the world economy, forecasting continuing strong growth, subdued inflation, gradual moderation of trade imbalances, and stable long-term interest rates.

Could that forecast go seriously wrong? If so, why? Here are some possibilities

A resurgence of global inflation

Major industrial nations are operating at or close to the limits of their potential, energy and commodity prices are buoyant, rising wages and declining productivity growth are boosting labour costs in the US and the money and credit bubble continues to expand very rapidly.

"While the commitment of central bankers to the pursuit of price stability has never been stronger," the BIS says, they could make policy misjudgments, as there is increasing uncertainty among them about how to deal with inflation.

The reverse could happen deflation

If the crisis in the American housing market deepens, the supply of credit will tighten. With wage growth sluggish and job losses in the construction industry, consumer confidence could take a hit. Growth in the US, the locomotive of the world economy, could fall sharply, impacting on business confidence. Other major economies might not provide compensating growth, as they have been depending on strong growth in their exports, primarily to the US.

Central bankers are more frightened by the prospect of deflation than by inflation, as it's much harder to combat.

Currency shocks

Abundant cheap credit and interest-rate differentials have produced massive capital flows, such as the carry trade, where speculators borrow in low-interest countries such as Japan and Switzerland and invest the money in high-interest ones such as New Zealand and Hungary. Those flows could suddenly go into reverse.

The dollar "clearly remains vulnerable" to loss of confidence by the private sector and loss of willingness of foreign central banks and governments to continue investing so much in dollar bonds and bank deposits.

Financial crisis

"Prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003," says the BIS. This has encouraged "more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking."

Financial institutions have been manufacturing an abundance of products such as CDOs bond-like packages of mortgages and other forms of debt and selling them to investors at great profit. Nearly $1 trillion-worth of CDOs alone were issued last year.

Banks may now be carrying a significant degree of credit risk on their books. But even if they have been able to distribute loans risk by paying others to take them over, "who now holds these risks, and can they manage them adequately?" the BIS asks. "The honest answer is that we do not know.

"Much of the risk is embodied in various forms of asset-backed securities of growing complexity and opacity.

"They have been purchased by a wide range of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals."

They have been encouraged by the high ratings given to such products, suggesting low risk. However the BIS warns: "The ratings reflect only expected credit losses, and not the unusually high probability of tail events." Tail events are those that happen rarely.

The BIS admits the common factor linking all the above concerns is "highly accommodating financial conditions." And who has been mainly responsible for those conditions? Why, the central banks of major nations, of course. They are the ones who have pursued the policies of cheap, easy credit aggressively, encouraging financial speculation.

How should we react to the BIS's dire warnings?

If there were to be a global financial crisis, it would be impossible to avoid its consequences. But you would be in a better position to ride out the crisis if you:

• Have no personal debt. Or at least have a high proportion of your debt in the form of loans that you cannot be called upon to repay soon, and preferably are at fixed rates of interest.
• Have a personal spending pattern structured to minimize risk. Own your home with a low or no mortgage loan, spend less than you earn so you save regularly, avoid long-term spending commitments.
• Have a cache of "chaos money" stowed away in a secret place, and only intended to be used in the most extreme circumstances. Gold bullion coins are best.
• Have an investment portfolio with a significant component of very low risk assets such as the state bonds of financially conservative nations. Non-financial assets such as personally-managed income-yielding property would be good, too.

However, don't rush out to restructure your affairs along those lines in the expectation of disaster around the corner.

The BIS says you can't assess the probability of future risks. However the historical evidence is that financial catastrophes are extremely rare. If you ran your life on the basis of expectation of disaster you would miss out on almost all its pleasures, and you would never be wealthy.

As an investor, it's important to maintain a balance in your portfolio, as it is conducting your life. How you divide assets into speculative, growth, defensive, income-producing and "insurance" or chaos components will depend on your age, wealth and other personal considerations, including what you're comfortable with.

In my experience, 90 per cent of the bad things you fear might happen, don't. The pessimists are usually wrong, and it's the optimists who seize the opportunities to get rich.