RAPAPORT... Will the economic crisis destroy the diamond and jewelry business? Are we heading into a global depression? Trillions of dollars of wealth have evaporated over the past few weeks. Why is this happening, what does it mean and what will happen next?
Over the past few years, governments sought to extend economic growth through artificially low interest rates and a strong dollar. On a simplistic level, easy credit increased consumer demand, driving international production, global wealth and higher commodity prices. On a more sophisticated level, artificially low interest rates created huge, unsustainable demand for housing, resulting in surging housing prices and unprecedented phantom wealth. Phantom wealth because the value of housing was based on continued mortgage payments from a sector of the population that could not afford to make such payments unless the value of the housing kept going up. Trillions of dollars of phantom wealth were created by a huge housing Ponzi scheme.
The world’s greatest banks and financial institutions bought, sold, packaged, insured and institutionalized this phantom Ponzi wealth. When the housing crisis hit, it forced a vicious cycle of mortgage defaults, foreclosures and plummeting housing prices. The highly leveraged capital base of the world’s most secure, safe and protected financial institutions evaporated. Everybody thought that everybody else was protecting them, when, in fact, nobody was able to protect anybody.
Banks could no longer trust each other and they stopped lending to each other. The financial sector has not only lost trillions of dollars of capital base, it has lost its ability to provide liquidity and stabilize itself. A great credit freeze has set in and the only way out is government intervention. It is important to recognize that the issue is not simply the loss of jobs in the financial sector; it is the collapse of the financial sector. What happens when consumers can no longer buy things on credit? When ATM cash machines and credit cards stop working?
On Saturday, September 27, Senator Kent Conrad had this to say on the floor of the U.S. Senate. “It’s not just going to be Wall Street, the chairman of the Federal Reserve Bank has told us that if the credit lockup continues, three million to four million Americans will lose their jobs within the next six months.”
At this stage, Congress has no choice. The U.S. government must unlock the financial sector by taking over and/or guaranteeing the bad mortgage debt that is choking it. The financial Humpty Dumpty must be put back together again or many millions of Americans will lose their jobs. It’s show time. We are transcending politics and money. Survival is the order of the day.
Have things gotten so bad that they will have to get better? Perhaps, but it is more likely that things will get different rather than simply better. Economic solutions always involve trade-offs and, in complex situations, the law of unintended consequences rules. Interventions breed interventions and sometimes we jump from the pan into the fire. Sometimes the cure is worse than the disease.
What is clear is that the U.S. financial system has dangerously destabilized and that Congress and the Federal Reserve Bank have no choice but to keep the system liquid. The risk of recession/depression far outweighs all other considerations, including inflation. The government is like a fireman fighting to put out a dangerous blaze. Water damage (i.e., inflation) is, at best, a secondary consideration.
As far as the diamond and jewelry industry is concerned, it’s reasonable to expect a decline in U.S. consumption as the luxury wallet continues to shrink and the mood of society shifts away from conspicuous consumption. This year, Christmas might be over before it starts. On the other hand, you never know. Crisis brings people closer together emotionally and medium- to low-price jewelry is a great way to cement relationships. That’s what happened after 9/11.
Uncertainty about the near term dominates the mind-set of the international diamond community. Sales of commercial goods at this year’s important September Hong Kong show were less than last year but not bad considering the collapse of the Far East equity markets during the show. Big stones did not move as sellers held firm, refusing weak offers from fearful buyers. Overall, it is too early to discern the short-term impact of U.S. intervention.
As to the long term, it is clear that something very strong and important is taking place. The financial crisis and assorted government bailouts and interventions are creating a seismic event. While it’s still too early to measure the full inflationary impact of current rescue attempts, the financial earthquake will create an inflationary tsunami that may be well beyond anyone’s control. Readers are encouraged to read our July ’08 “Tsunami Warning” article for greater analysis.
The relationships between inflations and deflation, interest rates and liquidity, global wealth and commodity prices, the dollar and gold will all play themselves out over the next few months. All of these factors will greatly influence diamond demand and prices. Those who predict the demise of the diamond markets fail to appreciate the complex nature of diamond demand. A demand that is nurtured, not just by the emotional and luxury aspects of the product, but also by diamond’s unique role as a store of value in troubled times.
Article from the Rapaport Magazine - October 2008. To subscribe click here.