Andreas Whittam Smith: The credit crunch will be with us for years to come

The crisis will be over when house prices in the US and Britain stop declining
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The Independent Online

To understand big events such as the current credit crisis, you need both horizontal and vertical knowledge. By horizontal knowledge, I mean taking into account a wide range of factors that might bear on the situation.

Professionals in the financial markets, for instance, often lack this dimension. They are compelled by the demands of their jobs to focus down onto a narrow range of detail. Ask somebody who deals in foreign exchange what he or she thinks about, say, stock market trends and they have little to say.

That sort of thing doesn't really matter until an unusual event occurs. Then there is much scratching of heads. By vertical knowledge, I refer to some understanding of relevant history. The present shortage of credit, for instance, as is exemplified by the withdrawal of some mortgage lenders from the UK market, is completely different from anything that has happened in the past 60 years but it does resemble episodes that took place in the 19th century.

George Soros, whose dire views about the economic outlook have been widely publicised in the past few days, has an abundance of both sorts of information. He is most famous in this country for being the man "who broke the Bank of England" when he sold short more than £5bn in the belief that Britain would be forced to withdraw from the European Exchange Rate Mechanism and to devalue the pound. And on Black Wednesday, 16 September 1992, that was exactly what happened.

But see how broad are his interests. He supported the Solidarity labour movement in Poland, as well as the Czechoslovakian human rights organisation, Charter 77. He funded Georgia's Rose Revolution. He watches and acts on political trends as much as on financial.

The merit of Mr Soros's remarks is that they take us on to what might happen next. The credit crisis has gone through successive, clearly marked phases, rather like the chapters in a book – and I guess that we are now about three-quarters of the way through the story. We have recently been turning the pages that cover the outbreak of forced selling by financial institutions which are on the brink of collapse. Now we are reaching a section entitled – "how the credit crunch began to affect ordinary people".

I agree with Mr Soros that recession in the US and the UK is inevitable. Britain is as vulnerable as the US, though in different ways. The finance industry is much more important to the UK. The indebtedness of British households is even greater relative to income than it is across the Atlantic.

If one were to ask Mr Soros how many more stages must the crisis pass through before it is over, he would say that he has two further concerns. The first relates to the market which provides financial institutions with insurance against credit defaults. The volume of such business has been huge. But as the crisis winds on, there is a growing fear that some of these insurance contracts will not be honoured.

Mr Soros also worries that the volume of foreclosures in the American and British home loans markets will be much more serious than lenders are currently assuming.

My answer to the same question would be slightly different. The crisis will be over when house prices in the US and in Britain stop declining and when a similar movement in commercial property comes to an end. For each downward step in property values further weakens the security that banks have taken as collateral for their loans. These trends might peter out and come to an end in the next 12 to 18 months.

But when the crisis itself is over, the consequences will linger on for a considerable period of time. For alongside the stock markets, the banks are at the heart of the mechanism that creates wealth. Banking arrived first. The Italians were the pioneers in taking deposits and lending out a safe proportion to business – hence Lombard Street in the City of London. Later came stock markets, which transform savings into capital, a Dutch innovation of the 17th century.

When banks make huge losses by reckless lending, only some of the larger and better known names can replenish their capital. Yet even these, like all the rest, instantly become much more careful. They restrict credit and in so doing restrain economic activity.

And their caution is likely to last as long as the cohort of managers of banks who have faced the crisis and dealt with it remain in post – perhaps for the next five to ten years. That is why it will be a long time before things return to normal – unless "normal" is redefined as something much more subdued than recent exciting times.

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