Jeremy Warner's Outlook: Bank of England frets as R word looms

Mining looks like the business to be in; Goldman and the art of making money
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The Independent Online

Alan Greenspan, the former chairman of the US Federal Reserve, was much mocked, not least by this column, when he said earlier this year that he thought there was a one-third chance of recession. My own amusement was not so much with the substance of Mr Greenspan's analysis as the spectacle of someone who used to speak only in runes suddenly expressing himself so plainly. Nonetheless, the one-third probability was by no means a consensus view at the time.

Over the past week, Mr Greenspan has narrowed the odds further to just a little under 50 per cent, and now everyone is beginning to think that – ooh-er – he might be right after all. The US economy seems to be sliding fast, pulled down by the travails of the housing market. Notwithstanding the boom in Asia, Japan is once more sinking back into its bad old ways, with the economy showing an outright contraction in the second quarter. Business confidence surveys in Germany and France meanwhile point to a sharply slowing eurozone economy.

The only obvious exceptions to this worryingly bleaker picture are the developing world, which seems still to be firing on all cylinders, and perhaps Britain too, which in the second quarter was growing at an annualised rate of 3.1 per cent. In Britain's case, however, this was the position BC, or "before the credit crunch".

What the picture looks like AD is still anyone's guess. The evidence is mixed. What we do know is that the financial sector, of huge importance to the UK economy as a whole, will have slowed markedly over the summer. Certain elements of consumer spending too have been subdued, though it is still not clear how much of that is due to the poor summer weather.

What's more, the Bank of England's own credit survey points to tightened corporate credit conditions in response to the turmoil in the interbank market. Interestingly, there is apparently no effect as yet on consumer or mortgage lending, the bit of the economy the Bank of England would be happy to see soften.

So should the Bank of England's Monetary Policy Committee, which has its monthly meeting next week, be thinking about following the US Federal Reserve into cutting interest rates? Even a few months back, such a course of action would have been unthinkable. Then the issue was still about when the MPC would next act to raise rates. That's plainly now off the agenda, but is it not still too soon to cut?

Despite the aforementioned points of weakness, the economy as a whole is almost certainly still growing reasonably strongly. Inflationary pressures persist. The case for cutting is therefore almost entirely about pre-emption and bolstering confidence in the financial markets. As we now know, that's not Mervyn King's style. The Governor of the Bank of England is instead for the stiff upper lip, for toughing it out.

"When the facts change, I change my mind," John Maynard Keynes once famously said. "What do you do, sir?" The pragmatic question for the MPC is that of have these facts changed enough? The Bank of England has been repeatedly wrong-footed in its handling of the credit crisis so far. Might it be in danger of making the same mistakes with monetary policy? Despite all the criticism he's come in for over the past month, I doubt the Governor is for turning, but oh to be a fly on the wall at next week's meeting.

Mining looks like the business to be in

Here's an interesting factoid from Marius Kloppers, the incoming chief executive of the world's biggest mining finance house, BHP Billiton. The world market for copper is about 17.7 million tonnes a year. The decline in US housing starts thus far recorded will reduce this by just 80,000 tonnes at a time when demand from China and elsewhere in Asia is rising almost exponentially.

Whatever happens to the US economy, then, it is unlikely to have much of an effect on the boom in commodity prices. For the old cyclical pattern in metal prices to reassert itself would require a quite serious downturn in China, which, though inevitable at some stage, wouldn't in any case interfere with the long-term trend. This is virtually certain to be upwards until per-capita consumption of copper and other metals reaches the same level as that of the developed world.

China and other parts of Asia are developing at breathtaking speed, so this secular change in the pattern of demand for base metals and other commodities is likely to be quite compressed compared with similar development stories in the past – European and American industrialisation, post-war reconstruction in Europe and Japan, and so on – which happened more slowly.

Nobody knows how long the process will take, but barring war and pestilence, it's reasonable to assume a 10- to 20-year "super cycle". Obviously there are going to be ups and downs within this cycle depending on the state of the world economy as a whole. But in the scale of things they are unlikely to be significant as long as this huge new source of demand plays catch up. Once the most cyclical of industries, the mining sector is bizarrely coming to be seen as a defensive haven against economic and financial storm. No wonder Mr Kloppers is smiling. Few industries look as well placed for the long run as this one.

Goldman and the art of making money

However bad things get in the capital markets, Goldman Sachs always seems to come out of it all smelling of roses. Third-quarter profits announced a week ago smashed all expectations, despite big write offs in connection with the sub-prime meltdown.

Goldman has even managed to make money out of the $2bn of rescue finance it provided to one of its hedge funds. Apparently there is a crisis at the heart of the very same global capital markets from which Goldman Sachs makes its money. There is no evidence of it in the Goldman Sachs numbers.

What's their secret? All market professionals claim to be good at hedging, but none seem to be quite so good as Goldman, which had prepared for market conditions of exactly the type we've just witnessed. Even as it was riding the boom in credit, it was hedging itself against the bet going wrong. As the value of the bet plummeted, the value of the hedge soared.

As the market snaps back, as in some areas it now seems to be, the difficulty is in getting out of the hedges. Always one step ahead of the game, Goldman seems to be hedged against that too. As everyone else is getting into the hedges, Goldman Sachs is busy getting out. What a pity they didn't have the same foresight at Northern Rock.

As it happens, Goldman Sachs is making money out of this debacle too. It is adviser to the tripartite committee of the Treasury, the Bank of England and the Financial Services Authority on how the public sector should be extracting itself from the mess. Don't you just hate these clever-clog investment bankers sometimes. All the same, it is perhaps just as well they are now such an important part of the UK economy. Better to have them here than somewhere else.

Rightly, the authorities have been lambasted throughout the crisis in credit markets for failing in their regulatory and crisis management duties. Yet stepping back from the immediacy of the present turbulence, and looking at the broad sweep of the past 10 years, they seem to have got a lot more right than wrong.

London's thriving financial district, together with the economic activity around the country that feeds off it, is evidence of that. Other countries would kill for such financial hegemony. Benign regulation is a large part of that success.

In reforming the system, it is therefore vitally important that the baby isn't thrown out with the bathwater. It is by no means yet proven that the Bank of England's tough-guy approach in refusing to provide financial support to credit markets is the wrong one. At the moment, it is widely seen as having undermined the City's reputation for sure-touch regulation. The judgement of history may be kinder.