Jeremy Warner's Outlook: The banking crisis is not so different to previous ones, but policy response is

The London stock market has slipped back into 'bear' market territory
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The Independent Online

A grim week for economic data has been topped off with news that US unemployment last month leapt to 6.1 per cent, a much bigger rise than expected and the highest level in nearly five years. The 3 per cent-plus growth recorded for the US economy in the second quarter seems to have been just a blip, explained mainly by the timing of the tax rebate package. America seems inexorably to be slipping towards recession.

Back home, the news looks even worse. Car sales and house prices are slumping. With no end in sight to the already year-old credit squeeze, it's hard to see from where salvation might come. The OECD predicts that, alone among the G7 nations, we'll actually be in recession during the second half of the year, albeit only marginally, with contractions of 0.3 and 0.4 per cent for the third and fourth quarters respectively.

The Government's housing package will have zero impact on this outcome, while the Chancellor's ill-judged remarks last weekend about economic conditions being the worst in 60 years may have further exacerbated the downturn by spreading gloom and despondency.

No wonder the London stock market has slipped back into "bear" market territory over the last week. Corporate Britain is now in full-scale defensive mode. Investment plans are being slashed and costs are being cut as executives switch the prevailing mentality from expansion to survival. Consumers have already tightened. Now it is the turn of companies.

As yet, this has not been reflected in a significant rise in unemployment. As I've reflected before, part of the explanation may be that high levels of eastern European migrant labour are acting as an important pressure valve, with redundant workers returning home rather than, as would have happened in previous economic downturns, swelling the ranks of the unemployed.

With the exchange rate and the jobs market no longer working in their favour, many such workers are quitting for the now booming emerging-market economies of their own home countries. Unfortunately, this is not a wholly fortuitous phenomenon for the UK economy, for, though it relieves pressure on the jobs market, it also strips demand out of the economy. If half a million eastern Europeans return home, that's half a million fewer buying food, accommodation and flat-screen TVs.

In any case, less spending by corporations and migrant workers is adding to the pressure on aggregate demand. There is already evidence of the multiplier effect associated with Keynesian economics kicking in. Less demand equals fewer jobs, equals even less demand, and so on. For the time being, the Bank of England is impotent to respond to these pressures with lower interest rates.

Relatively high inflation has severely limited its room for manoeuvre, though, the way things are going, the Bank may soon have to forget its inflationary scruples and, like the Federal Reserve in the US, cut sharply regardless of what's happening to prices.

So is it finally abandon all hope ye who enter here? Far from it. Throughout the unfolding crisis of the last year, I've held a more optimistic view of the likely end game than most. Swimming against the tide, increasingly desperately it might seem, I see no reason to change that view.

Despite what the Chancellor might or might not have said (he claims to have been taken out of context), it still seems to me quite unlikely that there will be a downturn as serious as that of the early 1990s, let alone the mid-1970s or the short, sharp shock recession of the early 1980s. These were all pretty miserable periods, and we aren't anywhere close to them yet.

Nor, in truth, are the policy challenges associated with this downturn quite as daunting as they were in any of these three previous recessions, all of which were associated with much more serious inflationary problems than we have now.

What appears to make this one different is the nature of the accompanying banking crisis, which began before the downturn set in and can therefore be thought partly culpable. The financial crisis makes the trajectory and duration of the downturn far less easy to predict. These are uncharted waters.

Or are they? In fact, it has long seemed to me that the present banking implosion is not much different from previous ones; it conforms to the pattern of banking crises down the ages. As the good times roll, there is a collapse in lending standards, made more acute this time around by the practice of securitisation which lulled practitioners into thinking they had discovered the holy grail of banking, the ability to lend without risk.

In any case, risk premia become compressed, and in the search for yield, capital gets concentrated in areas it shouldn't. In the technology boom, it was telecoms and dotcoms. This time around, it was housing, leveraged loans and consumer credit. Eventually, inflation begins to build, interest rates rise and the extent of the capital misallocation becomes exposed. Confidence in the banking system collapses. There then follows a painful workout as the debt overhang is unwound. With little credit left for anything else, the economy contracts.

Forgive the economics lesson, but I cannot see how the present financial crisis differs in substance from this oft-repeated pattern. Deregulation or, more particularly, failure to regulate key areas of financial innovation, may have compounded the excess this time around, while globalisation has also made it more contagious. But essentially it is the same.

On the other hand, the policy response seems to me to have been considerably more effective. Knowing what damage these implosions can do to the wider economy, policymakers have been working through the night to try to extinguish the fires. In most regards, they seem to be succeeding. The number of overt banking failures has so far been quite limited for what is supposed to be "the worst financial crisis since the Great Depression".

Eventually, there will be a quid pro quo for the massive taxpayer- funded bail-outs the banking system is receiving. In future, bankers will find themselves much more tightly constrained by capital controls and prudential oversight. This, in turn, will limit the ability of bankers to take risk, and therefore constrain economic growth. Lower growth may be part of the price that has to be paid for a more stable world.

As for the slowdown in the real economy, help is already on the way. The collapse this year in the price of sterling is helping to make our industries more competitive, even if it makes the Bank of England's task in fighting inflation harder.

Falling house prices, though obviously not good for the myriad of industries whose livelihood depends on the housing market, is for most people of little consequence, and by making housing more affordable will, in time, come to be seen as a positive boon.

The read-through from all this to the stock market remains as difficult to judge as ever. Ultimately, stock market valuations depend on the outlook for corporate profits, and this has plainly deteriorated sharply over the last year. Some pundits, such as Albert Edwards and James Montier at Société Générale, think we are on the verge of a veritable collapse in earnings. This tends to be the pattern in a downturn, when the buoyant profits reported at the top of the boom turn out to be something of an illusion.

Outside the banking sector, we've not yet seen any corporate scandals of any significance, involving the deliberate window dressing of profits and accounts. These are presumably yet to come. In a boom, there is always manipulation of profits, but few companies have yet admitted to it this time around. Have stock markets already discounted the likely hit to earnings through the corrections they have experienced over the last year?

If I'm right in my more optimistic assessment of the economy, then we may already be close to the bottom. Growth may be low to non- existent from here through to 2010, but that is not the same thing as economic catastrophe. Rather, it is a long overdue adjustment.