Hamish McRae: 2008: A recession in Britain, and oil at $175 a barrel. Or is that too outrageous?

Click to follow
The Independent Online

It is that time of year when the professional make their customary predictions about the world economy and markets for the forthcoming year, and a pretty downbeat lot they are.

If one were to try to distil the main economic messages, these would be that there will be a slowdown in the US that may or may not turn into a recession, that this will depress growth in Europe, but that growth in Asia will race on.

The parallel messages for the markets are similarly sober: a year when shares and bonds move sideways and that opportunities will be in specific areas that at present look bombed out, including banks and property.

In other words, most of the comment is on the lines of "more of the same". To say that is vastly to over-simplify, and there are interesting shades of difference between the protagonists: for example, while the balance of opinion is that the US will not have a recession next year, quite a few commentators put the possibility at evens. But the tone is almost universally cautious, and I think the explanation for that is that the professional forecasters have been pretty battered over the past year by their failure to pick up the dangers that the markets were running and the mayhem in the second half of this year.

I cannot find a single reference, on an admittedly quick look at last year's crop of forecasts, to the possibility of a liquidity crisis. Nor was there much about the possibility of the oil price doubling or the dollar falling as sharply as it has done. There were references, including some on these pages, to the overvaluation of house prices worldwide, and some of us reckoned that the end of this economic cycle would in some way be associated with falling property prices. But I know I saw the explosive growth of the hedge funds as the major source of potential weakness in the financial system, rather than the antics of mainstream banks. Some of the hedge funds have run into problems, but they have not destabilised the system, while the banks have.

Why did we miss this? The best explanation I have heard is the barbell one. On one side of the barbell are the experts who constructed the complicated financial instruments that bundled together the sub-prime debts and then created the off-balance sheet entities that apparently relieved the banks of these debts. They were so close to the minutiae of what they were doing that they did not appreciate the dangers or see the links in the financial system. On the other side of the barbell were the generalists, the economists and bankers, who understood the system but did not know enough about the intricacies of these instruments to see how they might unravel. Hardly anyone was in the middle, understanding both sides.

Are there similar black holes in our understanding now, and how severe will the consequences of these past months of mayhem be?

I don't think there is anything analogous to the credit crunch just round the corner, aside from the usual suspects of the financial imbalances between the US and Asia leading to a collapse of the dollar rather than the slow slide so far experienced. I suppose the dangers of some financial disruption in China or India should trouble people, but I think the main theme of the coming year will be sorting out the consequences of the past year's excesses. There are several more months of disruption to come.

You can see quite how suddenly the money market chaos struck from the first graph. It shows the gap between the three-month dollar interbank rate and the US Fed Funds target rate. The gap was dead steady until August, then suddenly shot all over the place. It is particularly wide at the moment as banks scramble to garner enough cash to make the year-end balance sheets look all right. Gradually next year it will come down, but banks all over the world will be reluctant to lend money except on watertight terms. Credit may become cheaper, but it will not become more available. As a result, power will shift to entities that have lots of cash, cash-rich companies, sovereign investment funds and the like. It will also shift regionally, towards the Middle East and Asia, and away from the US, and to a lesser extent the UK.

The shift of power away from the US will also be associated with some sort of slowdown there. That has already begun. The second graph shows some assessments from Barclays Capital of the profile of US and world growth through the second half of this year and then on through 2008. You see the main message: a sharp slowdown in the US (though not a recession) but a slower one for the world as a whole.

It would be nave to think that the UK will escape unscathed, but I have only seen one prediction that we too might slip into recession next year. That comes from Saxo Bank in Copenhagen, which deliberately sets out some "outrageous predictions" things that it does not expect to happen but just might. Among these are oil to $175 a barrel and a fall in the Chinese stock market of 40 per cent by year end. Were oil to go to that level the rest might follow.

Perhaps the most interesting question next year will be the ability of the emerging world, and in particular Asia, to decouple from the slowdown in the developed world. Can they race on if we slow down? To some extent the answer must be "yes", but I do think it is right to flag up some warnings.

One of the most alarming features of the past year, alarming in particular for the emerging economies, has been the surge in the price of food. You can see what has happened in the final graph. Part of the reason for that has been misplaced eco-friendly policies: taking food crops and turning them into fuel. But part has also been rising demand in China and elsewhere, including rising demand for meat. As living standards continue to rise throughout Asia such demand will probably carry on increasing. This is good news for the farmers of North America and Brazil, but it is adding to global inflation, and is particularly hard on poorer people in poorer countries. Rising food prices could bring serious disruption, social as well as economic, to the world next year.

The big point here is that we all know there will be some sort of downturn in the next couple of years but we don't know the timing or the severity.

My own instinct is that the year to worry about is 2009 rather than 2008, because I think there is sufficient momentum in the world economy to carry us through most of next year. But that may underestimate the severity of a US downturn.

Our parochial concern in the UK must surely be that were a downturn to come it would not be easy to offset a fall in demand by increasing the budget deficit, for we are not in as strong a fiscal position as we were in the last cycle. That may appear to be Alistair Darling's problem, but of course it is also ours.