Queue that stretched around the world: How run on the Rock changed financial landscape of Britain

The immediate panic over Northern Rock may be over, but we still have to come to terms with the powerful forces driving the world economy from which it derived – the massive US current account deficit, Asia's huge savings and the surge in commodity prices. Hamish McRae examines what the future may hold now the queues have melted away
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The Independent Online

The UK economy

British economic growth is likely to slow next year and that slowing will be influenced by the Northern Rock débâcle. There can be no doubt that whatever happens to Northern Rock itself, all banks will be more cautious about their lending policies. If banks lend less, or on more stringent terms, that directly affects demand for goods and services. The key issues now are how much growth will be hit by the banking troubles and how much it would have slowed anyway, and whether Britain's long boom, which has run since 1992, is drawing towards a close.

Growth in the first half of this year has been around 3 per cent annual rate. That is faster than the long-term trend of around 2.5 per cent and faster than most other developed economies, including the US. It has been supported by strong consumption, with retail sales in August running nearly 5 per cent up year on year. But that growth has been supported by borrowing, and strong consumption sucks in more imports.

Looked at nationally, there has been a cost in the form of a rising current account deficit, and the Government's own budget deficit is stuck at just under 3 per cent of GDP. (Tomorrow there will be new government borrowing figures. These are expected to show that it is still overshooting its own borrowing targets.)

So this is a boom that has been supported by borrowing, both by individuals and by the previous chancellor. Pressure from the banks will start to trim the former. The new Chancellor has to decide about the latter. Since he also has to cut the growth of public spending, expect a transition there too. The main forecasters have yet to incorporate the banking crisis into their forecasts for next year but when they do, expect growth for 2008 close to 2 per cent – that's assuming there is no serious fall in UK house prices.

The housing market

The housing boom has mirrored the economic boom, starting its present run in the early 1990s. What has been happening in the UK has parallels elsewhere, but British house prices have risen by more than those in any other large economy. This has been fuelled partly by inward migration, which has increased demand for housing; partly by restrictive planning policy; partly (in London) by large bonuses for financial service staff; and partly by generally easy lending conditions in the UK and elsewhere – including in the case of Northern Rock, mortgages of up to 125 per cent of a property's value.

However, even before the Northern Rock crisis there were signs of a turn in the market. Some sectors, such as buy-to-let flats, have been weak for several months as the return on rents has slipped below the costs of interest on borrowed capital. News of the first clear fall in prices nationally came through from the Royal Institution of Chartered Surveyors just as the crisis broke. That was coincidence and it was only a one-month decline. Nevertheless it may signal a peak in prices.

The issue now is whether prices will move to a plateau, with very low or nil growth in prices, or whether they will fall back. Economists calculate that UK house prices are somewhere between 10 and 30 per cent overpriced: that is, they are that much higher than the levels justified by people's incomes and by long-run supply and demand. That suggests that even if prices do not fall, they will not rise significantly until the growth of wages catches up, which could be as long as five years.

Banking and savings

Britons currently save a smaller proportion of their incomes than they have at any stage during the past half-century. Part of the reason for that is that rising property prices have made people feel they have less need to save: their wealth is rising at a rate that would dwarf any new savings that they might be able to make out of income. Savings are now expected to rise.

One reason why they may do so is that banks will be less willing to lend, not just on property (see next item) but more generally. The immediate cause of Northern Rock's difficulties was its inability to borrow funds from other banks on the money markets. Banks were unsure of their own cash needs and accordingly did not place funds back on the markets as their own deposits matured. This is a global phenomenon, but London banks relying on these markets for funding have been squeezed.

This freezing up of the inter-bank markets eased a little last week, helped partly by the Bank of England lending money to it. But confidence remains weak, and bankers think it will take several months before the markets function normally. It is unlikely that there will be another run on a British bank, but this death of credit will affect all forms of finance.

Any organisation or business that relies heavily on debt will be at a disadvantage; by contrast, any business that has spare cash will find it has all sorts of opportunities to pick up assets on the cheap. This will encourage businesses, as well as private individuals, to try to save more, suggesting that the whole climate of easy money – that the best policy is to borrow and borrow big – is reversing itself.

Mortgages

It will be harder to get a mortgage for two reasons – but the costs will eventually come down. One obvious reason for the decline in supply is that Northern Rock was doing nearly 20 per cent of UK mortgages when the crash came. Whatever its future, it is not going to be lending much money in the coming months. Most probably it will be taken over and dismembered. That takes supply out of the mortgage market. The flow of new mortgages seems to be down by about a quarter. That is a huge shift.

The second reason is a decline in competition for business. All lenders were already tightening terms even before Northern Rock crashed. They were requiring larger deposits and tougher interest rates in the early part of the payback period. Interest-only mortgages were harder to get. Now, with the most aggressive lender out of the market, the rest can pick and choose the business they want without fearing that they may be underbid.

However, the cost of mortgages is unlikely to rise and may soon start to fall. The obvious reason for that is that the Bank of England will start to cut interest rates (see below) but also that longer-term rates seem set to stabilise too.

If the cost of getting a fixed rate for two to five years – key for many people now having to refinance – does ease, that will go a long way to relieving general mortgage pain. The main reason for this shift is that up to now banks have been curbing demand by price; now they are shifting to curbing demand by availability. We are going back to rationing mortgages rather than simply making them more expensive.

Interest rates, sterling and share prices

Interest rates will not now go up. That is a direct result of the run on Northern Rock, and because mortgages will be restricted by supply, there won't be so much need to restrict them by price. Guesses on the timing of the first cut are open, since this depends on the extent to which the economy slows, but the markets do now expect something before Christmas. A typical prediction is that interest rates will be down to 5 per cent by the middle of next year.

This change of perception is affecting the pound, which has fallen sharply against the euro, and even slightly against a weak dollar. A more serious fall would be troubling for it would increase inflation as the cost of imports, including energy, rose. But a somewhat weaker sterling helps exports and underlying company profits.

Partly as a result, prospects for shares have improved. There has been the immediate recovery following the rebuilding of confidence as a result of the Government's intervention. But some equity strategists believe that the fall in US interest rates – and the fact that eurozone rates are likely to fall too – will prolong this expansion of the world economy. So one silver lining in the cloud created by the general banking disruption of the summer is that shares worldwide should recover.

The world economy

In the short term the disruption of the summer has dealt a serious blow to confidence and growth in the US, and a lesser blow to confidence (but not yet growth) on the Continent. But the world economy is now driven as much by the "new" entrants to the global stage, China and India, and to a lesser extent Russia and Brazil (the so-called Bric group), as it is by the US or Europe. These economies are racing along and have been completely unfazed by the banking crisis in the "old" economies.

So the world economy seems set to carry on growing through next year, though maybe at a somewhat slower pace. Much of the ground lost by the US, the EU and Japan will be made up by the Bric group.

How long the stimulus from lower interest rates – particularly in the United States – will last is not clear. But for the moment, global economic prospects look rather brighter now than they did a week ago.

In the frame for blame

A week of drama in the City – and beyond – saw MPs, savers and banking executives embark on a witch-hunt. By last Friday, calls for Mervyn King's head were being drowned out by disapproval of the way the Financial Services Authority had handled the crisis. Here are the potential scapegoats

Gordon Brown, PM

The man who, during his time as Chancellor, was responsible for fostering the excessive borrowing binge that lies behind the credit crunch could yet feel the heat from the banking crisis. Ultimately, he must take the blame for creating a climate of financial instability.

Alistair Darling, Chancellor of the Exchequer

Was slow to wake up to the task in hand but came good in the end with a cash guarantee to reassure nervous Northern Rock savers. He is now looking to devise a new deposit insurance scheme to ensure that history does not repeat itself.

Mervyn King, Governor of the Bank of England

His U-turn over the £10bn liquidity injection has destroyed his reputation for consistency. Despite calls for his head, the Government is likely to renew his five-year term next year because it would not dare do otherwise.

Sir John Gieve, Deputy governor of the Bank of England

The financial stability expert who sits on the Financial Services Authority (FSA) board is accused of being asleep on the job. He is tipped as the most likely fall guy for the Northern Rock affair. He took a fortnight's holiday at the start of the crisis.

Sir Callum McCarthy, Chairman, Financial Services Authority

In the firing line for not clamping down on Northern Rock's aggressive financial practices sooner or warning savers of the danger they faced. Was dubbed an "arguido" (Portuguese for official suspect) during grilling by MPs.

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