We're not out of the woods yet

WITH equity markets now rebounding strongly, anyone would think that this summer's global economic crisis will become no more than a footnote in history. The truth, however, is that we are now entering a new and possibly more dangerous phase for the Western world. The key point is this. Up until now the worst effects of the crisis have been confined to Asia and, more recently, Latin America. But as these countries strive to deal with their own problems, there will be potentially painful knock- on effects for both the US and Western Europe.

The most obvious dangers have already been well documented. As countries in Latin America, for example, go into recession so the prospects for Western export growth will deteriorate. US exports have been falling for much of this year and are now beginning to contribute to a more widespread slowdown in the US economy. European countries have also experienced much weaker export performance in recent months.

But it is the hidden risks which have left policy makers scratching their heads since the summer. The biggest worry must be the possible development of a credit crunch, particularly in the US. A credit crunch occurs when banks and other financial institutions begin to panic over the creditworthiness of actual and prospective borrowers. For any given level of interest rates, this means that loan growth begins to slow. The whole process then becomes self-feeding. Less lending increases default risk which, in turn, leads to even lower lending. The economy starts to spiral downwards.

In late September and early October, clear signs of a tightening of credit conditions began to come through in the US, stemming from the Russian default and the bad news on hedge fund exposure. Credit spreads widened and surveys suggested a new, much more cautious, approach from banks. In response, the Federal Reserve cut interest rates twice within a few weeks.

Since then, the situation has improved. Credit spreads are not so extreme and there have been fewer complaints about illiquidity in, for example, the corporate bond market. Nevertheless, spreads are still considerably wider than before the Russian crisis. As a result, it looks as though the Federal Reserve will continue to focus on the risk - if not the reality - of a credit crunch.

There is one simple approach in these situations: get interest rates down fast. Once credit crunches begin to spread, they become very hard to control. Japan was far too slow in cutting rates in the early 1990s and, partly as a result, has suffered a total absence of bank lending growth ever since. Over the same period, the Federal Reserve was far more successful - rates fell from a peak of over 9 per cent to a trough of only 3 per cent in just three years. Without this rapid action, the subsequent strong performance of the US economy would not have been possible.

Under these circumstances, there are two rules of thumb. First, the central bank should get real (inflation-adjusted) interest rates down to below the long-run average. Second, it should cut rates fast enough to generate an upward-sloping yield curve. Given that banks typically borrow short and lend long, this improves their overall profitability and encourages them to start lending again. To achieve these twin objectives, the Federal Reserve's key interest rate will have to fall from 5 per cent currently to 4 per cent or lower by the middle of next year.

Fortunately, the Federal Reserve has plenty of room to act. The economy is slowing and inflationary pressures are minimal (other than within the equity market). Swift action now, with hopefully another rate cut this week, should ensure that the US avoids recession.

Lower US interest rates may be a good thing but, in more ways than one, the Federal Reserve may simply end up "passing the buck" of global economic adjustment to other countries. After all, lower US rates presumably imply a lower dollar and hence a stronger euro. America's gain may, on this basis, turn into Europe's export loss. What can be done?

The most obvious response is for the European Central Bank (ECB) to cut rates. And, to be fair, that is exactly what has been happening. The process of convergence towards a single European interest rate has basically meant that Italian, Spanish, Portuguese and Irish interest rates are gradually falling to German and French levels, so bringing the average European interest rate down from rates that are already at very low levels.

Additional action, however, may be less forthcoming. Faced with increasingly vocal demands from European politicians for easier monetary policy, the ECB could simply refuse to cut interest rates in an effort to maintain credibility.

This, however, could prove to be a dangerous game. Europe cannot hope to insulate itself from developments elsewhere in the world. As Asian countries move into balance of payments surpluses and emerging markets are forced to cut their balance of payments deficits, the Western world will have to move into smaller surplus or larger deficit (after all, the global economy cannot be in either surplus or deficit - unless we are trading with Mars).

In Europe's case, this leaves one of two options. Either a bias towards further monetary easing is put in place which keeps a lid on the euro and supports domestic investment and consumer spending, or the euro appreciates strongly. In the first case, balance of payments adjustment comes through strongly rising imports as a result of decent domestic growth. In the second case, adjustment comes through falling exports and, ultimately, big job losses.

In both the US and Europe, policy options exist to avoid a collapse in economic activity. In the US, these options can be taken quite easily. In Europe, the need for the ECB to build credibility, coupled with the increasingly vocal calls from politicians to cut rates, could lead to delay and confusion on monetary policy.

Stephen King is managing director, economics, at HSBC.

Start your day with The Independent, sign up for daily news emails
Arts and Entertainment
Joe Cocker performing on the Stravinski hall stage during the Montreux Jazz Festival, in Montreux, Switzerland in 2002
musicHe 'turned my song into an anthem', says former Beatle
Clarke Carlisle
footballStoke City vs Chelsea match report
Arts and Entertainment
theatreThe US stars who've taken to UK panto, from Hasselhoff to Hall
ebooksA year of political gossip, levity and intrigue from the sharpest pen in Westminster
Life and Style
Approaching sale shopping in a smart way means that you’ll get the most out of your money
life + styleSales shopping tips and tricks from the experts
newsIt was due to be auctioned off for charity
Coca-Cola has become one of the largest companies in the world to push staff towards switching off their voicemails, in a move intended to streamline operations and boost productivity
peopleCoca-Cola staff urged to switch it off to boost productivity
Sir David Attenborough
environment... as well as a plant and a spider
'That's the legal bit done. Now on to the ceremony!'
voicesThe fight for marriage equality isn't over yet, says Siobhan Fenton
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

The Jenrick Group: Night Shift Operations Manager

£43500 per annum + pension + holidays: The Jenrick Group: Night Shift Operatio...

SThree: Trainee Recruitment Consultant - LONDON

£20000 - £25000 per annum + OTE £40,000 + Car + Pension: SThree: SThree are a ...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £35K: SThree: We consistently strive to be the...

SThree: Graduate Recruitment Consultant

£20000 - £25000 per annum + OTE £35000: SThree: SThree are a global FTSE 250 b...

Day In a Page

Isis in Iraq: Yazidi girls killing themselves to escape rape and imprisonment by militants

'Jilan killed herself in the bathroom. She cut her wrists and hanged herself'

Yazidi girls killing themselves to escape rape and imprisonment
Ed Balls interview: 'If I think about the deficit when I'm playing the piano, it all goes wrong'

Ed Balls interview

'If I think about the deficit when I'm playing the piano, it all goes wrong'
He's behind you, dude!

US stars in UK panto

From David Hasselhoff to Jerry Hall
Grace Dent's Christmas Quiz: What are you – a festive curmudgeon or top of the tree?

Grace Dent's Christmas Quiz

What are you – a festive curmudgeon or top of the tree?
Nasa planning to build cloud cities in airships above Venus

Nasa planning to build cloud cities in airships above Venus

Planet’s surface is inhospitable to humans but 30 miles above it is almost perfect
Surrounded by high-rise flats is a little house filled with Lebanon’s history - clocks, rifles, frogmen’s uniforms and colonial helmets

Clocks, rifles, swords, frogmen’s uniforms

Surrounded by high-rise flats is a little house filled with Lebanon’s history
Return to Gaza: Four months on, the wounds left by Israel's bombardment have not yet healed

Four months after the bombardment, Gaza’s wounds are yet to heal

Kim Sengupta is reunited with a man whose plight mirrors the suffering of the Palestinian people
Gastric surgery: Is it really the answer to the UK's obesity epidemic?

Is gastric surgery really the answer to the UK's obesity epidemic?

Critics argue that it’s crazy to operate on healthy people just to stop them eating
Homeless Veterans appeal: Christmas charity auction Part 2 - now LIVE

Homeless Veterans appeal: Christmas charity auction

Bid on original art, or trips of a lifetime to Africa or the 'Corrie' set, and help Homeless Veterans
Pantomime rings the changes to welcome autistic theatre-goers

Autism-friendly theatre

Pantomime leads the pack in quest to welcome all
The week Hollywood got scared and had to grow up a bit

The week Hollywood got scared and had to grow up a bit

Sony suffered a chorus of disapproval after it withdrew 'The Interview', but it's not too late for it to take a stand, says Joan Smith
From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?

Panto dames: before and after

From Widow Twankey to Mother Goose, how do the men who play panto dames get themselves ready for the performance of a lifetime?
Thirties murder mystery novel is surprise runaway Christmas hit

Thirties murder mystery novel is surprise runaway Christmas hit

Booksellers say readers are turning away from dark modern thrillers and back to the golden age of crime writing
Anne-Marie Huby: 'Charities deserve the best,' says founder of JustGiving

Anne-Marie Huby: 'Charities deserve the best'

Ten million of us have used the JustGiving website to donate to good causes. Its co-founder says that being dynamic is as important as being kind
The botanist who hunts for giant trees at Kew Gardens

The man who hunts giants

A Kew Gardens botanist has found 25 new large tree species - and he's sure there are more out there