Jeremy Warner's Outlook: Some contrarian reasons for optimism

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The Independent Online

It was hard to find an optimistic voice among the ranks of senior bankers and other City dignitaries who attended the Governor of the Bank of England's cocktail party shortly before Christmas. One said that publicly at least it was his patriotic duty to be upbeat about the future. Yet privately he was extremely pessimistic.

Another said that Alan Greenspan was wrong in forecasting a 50 per cent likelihood of recession in the US: in fact, the chances were much higher and he felt in his waters that there would be a recession in the UK too.

In my experience of financial markets, things are never quite as good as they seem when the boom is in full swing, nor as bad as they appear when everyone is down in the dumps. The same is true today, with the mood among bankers one of abject doom and gloom.

Bankers, of course, have very good reason to be depressed. Over the past four months, many of them have been forced into staggeringly large bad-debt writedowns brought on by a lending folly which was entirely of their own making. Conditions in credit markets also very definitely point to a serious recession.

The market price of mortgage-backed securities discounts a much heavier level of defaults on home loans than we have in fact seen to date. What this suggests is that people are going to lose their jobs in their tens of thousands, provoking an eventual level of foreclosure not seen since the last major recession in the early 1990s.

Bankers, meanwhile, have been made to look negligent as well as reckless. Many of them have found themselves seriously short of capital, while some have been forced into the humiliation of seeking rescue finance from the sovereign wealth funds of the Middle East and Asia. The symbolism of these acts of prostration could scarcely be more powerful. They seem to be proof positive of the shifting power equation from West to East.

Yes, indeed. On the Richter scale of banking crises, this one measures a full force 10. Yet a banking crisis even as profound as this one doesn't necessarily mean there is going to be an economic crisis to match. My confidence in this view has been sorely tested over the past five months. At first, it seemed that central bankers had failed to recognise the gravity of the situation in credit markets and were therefore doing too little to address it.

Yet more recently these policy failings have been rectified in a manner which should allow Britain and Europe, and possibly the US too, to escape recession. And even if the US does sink into recession, the likelihood is of a shallow and short-lived one. Action in reducing interest rates and swamping the system with liquidity ought to ensure that the US economy is in recovery mode by the middle of next year.

There is already evidence to suggest that credit markets may have over-reacted to events. Most recessions are marked by an absence of liquidity as interest rates tighten to choke off inflationary pressures. That's not true this time around. Despite the credit crunch, liquidity is at record highs, fed by the savings of developing economies and the actions of central bankers in addressing the banking crisis.

The fact that this is not yet apparent in credit markets is explained by the relatively slow pace at which monetary action feeds through to developments in the real economy. Inflationary pressures to some extent limit the scope for further action. Even so, if the economy is slowing in any case, that in itself ought to cause inflation to fall further out, justifying looser policy still even as inflation is rising.

In the meantime, the backstop of still strong economic growth in the developing markets of Asia and Latin America should help save the West from the full consequences of the sub-prime meltdown. With luck, these emerging economies should provide sufficient fuel to the developed West to keep the engine ticking over.

A pronounced slowdown, which will for many feel painful, is a certainty. But the economic Armageddon that some commentators foresee continues to seem rather unlikely.

One leading industrialist whose spread of global business interests is usually a key cyclical indicator of downturns to come tells me he has seen no evidence of it at all so far, except maybe at the margin of Western property and construction markets. This is more than compensated for by rapid growth in Asia and the new technologies. His stock is valued for nil growth or worse. His budgets still point to 5 per cent-plus growth, with no reason to change them.

The same may be true of large parts of the stock market. It's hard to make the bull case for stocks with the mood so negative. Yet many of these stocks are already priced for recession think banks, property, leisure and retail. If it is reasonable to think there won't be one, then some mild uplift in stock prices next year continues to look a plausible way to bet.

I was optimistic in my outlook this time last year too, so my forecasts should perhaps come marked with a prominent health warning. Both the UK stock market and the economy have finished up on the year, partially vindicating my view, but they are also closing on a seriously downbeat note, with an undoubtedly troubled year ahead.

Watch them bounce towards the middle of next year is my call. When bankers are collectively this gloomy, it seems to me right to think the opposite.



Still no case for nationalising Rock

I also find myself swimming against the tide in thinking that nationalisation is entirely the wrong approach for the Government to be pursuing with Northern Rock. To be fair on ministers, this is a view largely propagated by the press and parts of the opposition. The Government's favoured approach is still that of finding a private sector solution.

Yet within the Treasury, the Bank of England and the Financial Services Authority, there is growing doubt over whether this is an achievable outcome. Hmmm.

There seem to me to be only two good arguments for nationalising the Rock, both of which have flaws. One is that it might enable the Government to have more control over the nearly 30bn it has lent to the troubled mortgage provider. The other is that since Northern Rock would be dogmeat without the Bank of England's lending and the Treasury's separate guarantee of dep-ositors, the company is already worthless from a shareholder point of view. It is therefore argued any upside that might exist once more settled credit conditions return belongs to the taxpayer, without whose support Northern Rock would no longer exist.

As to the first of these arguments, the Government's funds are largely secured against dec-ent security, so in theory there is nothing to be gained from having more direct control. Already the Northern Rock management cannot so much as take a pee without the Treasury's say-so, which partly explains the present paralysis. Northern Rock also has to pay a penalty rate of interest on the loans, so the taxpayer is already in effect being rewarded for the risk he is carrying.

Yet the more significant argument against nationalisation is a wider one. Britain's history of state ownership suggests powerfully that the Government does not make a good manager of business assets. This is more particularly the case with Northern Rock as there are jobs at stake in key Labour strongholds. Would the Government be able to make the tough decisions on downsizing and the rest that would be necessary to turn this company around? This strikes me as deeply unlikely.

There are precedents for successful state ownership of banks. Crdit Lyonnais was effectively nationalised by the French government in the early 1990s and eventually refloated for a big profit. Yet the circumstances were rather different, and the French banking system has in any case always been more hand in glove with the state than is common elsewhere. In the end, it comes down to whether the taxpayer is more likely to recover his 30bn by nationalising Northern Rock than leaving it up to the private sector to sort out the mess. To believe the former is a triumph of hope over experience.

j.warner@independent.co.uk

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