Jeremy Warner's Outlook: One year on, the crunch wrecking ball is playing havoc in the real economy

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The Independent Online

One year old today, the credit crunch is finally starting to make its full consequences felt in the real economy. When the crunch began a year ago, it was hard to figure out what all the fuss was about. The economy, and even the housing market, just kept on chugging along as if nothing had happened, a bit like one of those cartoon characters which continue to run on thin air long after they've left the edge of the cliff.

And so it might have continued but for soaring commodity prices. Looking at today's slowdown, it is impossible to disentangle one from another and say which is the more important in determining our economic woes.

One thing is certain. But for the surging oil price, and the effect that's had on inflation and demand, the economy wouldn't look as bad as it is, notwithstanding what some are calling the worst financial crisis since the Great Depression.

In the 1920s, a financial crisis rapidly turned into an economic calamity, but largely because of an incompetent or even non-existent policy response. It's not like that this time around. Steeped in the history of the Great Depression, Ben Bernanke, the chairman of the US Federal Reserve, has promised to do everything within his power to prevent the banking system from collapsing, and he's backed his words with actions.

Bailing out bankers must to many seem a distasteful practice. Auto workers and even media luvvies (always excepting the BBC) cannot expect the same protections if their companies run into difficulties. The creative destruction of the markets must be allowed to run its course, say the masters of the universe on Wall Street and in the City. Yet when it comes to them, a different rule applies.

Most of us can understand why it might be necessary to bail out depositor banks, with the savings of millions of ordinary people at stake. Yet the Fed has gone much further, in bailing out investment banks too, so serious did it think the consequences for the financial system and therefore the wider economy might be if it sat on its hands and did nothing.

In Europe and Britain, central bankers have likewise been leaning over backwards to mitigate the effects of the credit crunch, by providing liquidity, urging recapitalisations and, where necessary, facilitating rescues. But what they have not been able to do, because of runaway commodity prices, is slash interest rates to bolster demand.

For central bankers in Europe and Britain, at least, elevated levels of inflation have prevented the monetary easing that might have ensured a soft landing.

In the US, the Fed has been less concerned about inflation and cut rates dramatically. Combined with tax cuts, this has supported growth to the extent that the US economy now looks like weathering the credit crunch rather better than Europe and the UK, both of which are flirting with recession. There could scarcely be a greater irony, as the credit crisis finds its origins not in Europe but in the US sub-prime mortgage meltdown.

In any case, in dealing with the crisis, central bankers, and particularly the Fed, have thrown all principles of moral hazard to the wind. If they didn't know it before, bankers can now be certain that however excessively they behave, they will always be fully underwritten by policymakers desperate to protect their populations from economic catastrophe.

As economies head towards recession, we can expect a similar lack of constraint in fiscal policy. Never mind the niceties of prudential management of the public finances, there are jobs to protect. The choice seems to be that of the devil and the deep blue sea – a deflationary implosion such as was seen in the 1930s, or an inflationary, let-rip explosion, like the 1970s.

Royal Bank of Scotland posts record loss

It's remarkable what a little bit of news management can do. With investors primed to expect even worse, news that Royal Bank of Scotland has recorded the second biggest loss in UK banking history counted as not at all bad in the pantheon of doom and gloom that is today's stock market.

What seems to have thrown the analysts was that writedowns of £5.9bn were partially offset by a writeback of £812m on the bank's own loans, the result of a strange little accounting convention which dictates that if you write down the value of your assets you can take a proportionate chunk out of your liabilities, which logically must also be worth less.

Core tier-one capital also came in a little bit better than expected at 5.7 per cent, allowing Sir Fred Goodwin, the chief executive, to insist that he wouldn't be a forced seller of the insurance assets. RBS can afford to wait until the right price comes along, he said.

In most other respects, however, this was a gruesome set of results, which leaves many investors still aghast at why Sir Fred hasn't yet put himself through the shredder and been thrown out along with the CDOs. In the US, virtually the entire cadre of top banking bosses judged responsible for the credit crunch have been sacked, albeit dragging bag loads of compensation out behind them.

In no other industry would it be thought tolerable for the guy who got the company into such a mess to be entrusted with getting it out again. If there was an available alternative to Sir Fred, the board would presumably already have opted for it. Lack of succession planning may mean the bank has no option but to stick by its man.

I'm not going to defend Sir Fred, even if as an operational manager he remains hard to beat. The acquisition of ABN Amro last autumn as part of a consortium of European banks at a top of the market price was an extreme act of hubris and misjudgement for which RBS is now paying a heavy price.

A third of yesterday's write-downs relate directly to assets held by ABN. However effective the integration, it's going to take an awfully long time for the ABN purchase to reach pay-back time. The boss of Fortis, one of the other consortium bidders, has already been guillotined, yet still Sir Fred forges on. He must have the hide of a rhinoceros.

Even so, and without wishing in any way to belittle the significance of what's said to be the worst banking crisis since the Great Depression, I've long been of the view that actually it's not quite as bad as it looks.

Again, I'm not knocking the mark-to-market accounting that forces banks to mark down their credit exposures to levels which reflect what they can be sold for, but certainly it has greatly and unnecessarily added to the sense of crisis that has surrounded the banking industry. If held to maturity, most of these securities will eventually be worth a great deal more than they are trading at today. Underlying rates of default nowhere near justify present valuations and are quite unlikely to absent of a truly cataclysmic recession.

Yet the collapse in valuations has set in train a vicious circle of impairment which has trounced confidence in the banking sector and necessitated a series of rights issues or alternative equity offerings to restore capital ratios. As bankers have learned to their cost, part of the downside of the originate and securitise model of lending, which became the norm at the height of the credit boom, is that securities are by their nature a good deal more volatile than plain vanilla balance-sheet loans.

Forced by the liquidity crisis to sell asset and deleverage, the banks have had to dump their most liquid assets first, thereby depressing prices for even quite high quality mortgage-backed securities, further adding to impairment charges.

As Sir Fred says, only the brave would attempt to call the bottom of this process. We've already had any number of false ones. But it is beginning to look as if it may be largely over, with Merrill Lynch's clearing of Aegeon stables marking some sort of watershed.

Sir Fred will be hoping so, in any case, because he's now got a gathering conventional bad debt experience to deal with. According to the European Central Bank's latest survey of lending intentions, the most important factor in tightening credit conditions has moved from the cost of funds and balance sheet constraints to that of deteriorating expectations for the economic outlook. The first wave of the banking crisis may be over, but a second possibly more lethal one is fast approaching.