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.

The surrealist comedian at the Q Awards in 2010
Life and Style
Six of the 76 Goats' cheese samples contained a significant amount of sheep's cheese
food + drink
Russell Brand arriving for the book launch in East London
peopleRussell Brand cancels his book launch debate due to concerns about the make-up of the panel
Arts and Entertainment
Contestants during this summer's Celebrity Big Brother grand finale
tvBroadcaster attempts to change its image following sale to US
Arts and Entertainment
Sarah Dales attempts to sell British Breeze in the luxury scent task
tvReview: 'Apprentice' candidates on the verge of tears as they were ejected from the boardroom
New look: Zellweger at Elle's Women in Hollywood awards on Monday

Actress sees off speculation about her face in an amazing way


Florida mother launched a petition to ban the sale of the dolls

Arts and Entertainment

Marvel has released first teaser trailer week early after it leaked online

Life and Style
CHARGE BOOSTER: Aeroplane mode doesn't sound very exciting, but it can be a (phone) hacker's friend. Turning on the option while charging your mobile will increase the speed at which your phone battery charges
techNew book reveals how to rid your inbox of spam, protect your passwords and amplify your iPhone
Christiano Ronaldo enjoys his opening goal
champions leagueLiverpool 0 Real Madrid 3: Ronaldo and Benzema run Reds ragged to avenge thrashing from their last visit to Anfield
Arts and Entertainment
Awesome foursome: Sam Smith shows off his awards
music22-year-old confirms he is 2014’s breakout British music success
Arts and Entertainment
Sir Nicholas Serota has been a feature in the Power 100 top ten since its 2002 launch
Call me Superman: one of many unusual names chosen by Chinese students
newsChinese state TV offers advice for citizens picking a Western moniker
ebooksAn unforgettable anthology of contemporary reportage
Wilko Johnson is currently on his farewell tour
Let’s pretend: KidZania in Tokyo
educationKidZania lets children try their hands at being a firefighter, doctor or factory worker for the day
'Irritatingly Disneyfied': fashion vlogger Zoella
voicesVicky Chandler: Zoella shows us that feminism can come in all forms
Life and Style
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

IT Systems Business Analyst - Watford - £28k + bonus + benefits

£24000 - £28000 per annum + bonus & benefits: Ashdown Group: IT Business Syste...

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: The SThree group is a world le...

Trainee Recruitment Consultant Birmingham

£18000 - £23000 per annum + Comission: SThree: The SThree group is a world lea...

Trainee Recruitment Consultants

£20000 - £25000 per annum + OTE £Competitive: SThree: SThree Group and have be...

Day In a Page

How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?

A crime that reveals London's dark heart

How could three tourists have been battered within an inch of their lives by a burglar in a plush London hotel?
Meet 'Porridge' and 'Vampire': Chinese state TV is offering advice for citizens picking a Western moniker

Lost in translation: Western monikers

Chinese state TV is offering advice for citizens picking a Western moniker. Simon Usborne, who met a 'Porridge' and a 'Vampire' while in China, can see the problem
Handy hacks that make life easier: New book reveals how to rid your inbox of spam, protect your passwords and amplify your iPhone

Handy hacks that make life easier

New book reveals how to rid your email inbox of spam, protect your passwords and amplify your iPhone with a loo-roll
KidZania lets children try their hands at being a firefighter, doctor or factory worker for the day

KidZania: It's a small world

The new 'educational entertainment experience' in London's Shepherd's Bush will allow children to try out the jobs that are usually undertaken by adults, including firefighter, doctor or factory worker
Renée Zellweger's real crime has been to age in an industry that prizes women's youth over humanity

'Renée Zellweger's real crime was to age'

The actress's altered appearance raised eyebrows at Elle's Women in Hollywood awards on Monday
From Cinderella to The Jungle Book, Disney plans live-action remakes of animated classics

Disney plans live-action remakes of animated classics

From Cinderella to The Jungle Book, Patrick Grafton-Green wonders if they can ever recapture the old magic
Thousands of teenagers to visit battlefields of the First World War in new Government scheme

Pupils to visit First World War battlefields

A new Government scheme aims to bring the the horrors of the conflict to life over the next five years
The 10 best smartphone accessories

Make the most of your mobile: 10 best smartphone accessories

Try these add-ons for everything from secret charging to making sure you never lose your keys again
Mario Balotelli substituted at half-time against Real Madrid: Was this shirt swapping the real reason?

Liverpool v Real Madrid

Mario Balotelli substituted at half-time. Was shirt swapping the real reason?
West Indies tour of India: Hurricane set to sweep Windies into the shadows

Hurricane set to sweep Windies into the shadows

Decision to pull out of India tour leaves the WICB fighting for its existence with an off-field storm building
Indiana serial killer? Man arrested for murdering teenage prostitute confesses to six other murders - and police fear there could be many more

A new American serial killer?

Police fear man arrested for murder of teen prostitute could be responsible for killing spree dating back 20 years
Sweetie, the fake 10-year-old girl designed to catch online predators, claims her first scalp

Sting to trap paedophiles may not carry weight in UK courts

Computer image of ‘Sweetie’ represented entrapment, experts say
Fukushima nuclear crisis: Evacuees still stuck in cramped emergency housing three years on - and may never return home

Return to Fukushima – a land they will never call home again

Evacuees still stuck in cramped emergency housing three years on from nuclear disaster
Wildlife Photographer of the Year: Intimate image of resting lions claims top prize

Wildlife Photographer of the Year

Intimate image of resting lions claims top prize
Online petitions: Sign here to change the world

Want to change the world? Just sign here

The proliferation of online petitions allows us to register our protests at the touch of a button. But do they change anything?