This must be the turning point in the global financial crisis – "must" in the sense that, if there are greater financial collapses in the coming weeks, then the world economy itself really will be threatened. However the downward swing of the real economy has only just begun and, while there are still good reasons to believe that it will not be as deep as that of the 1980s or 1990s, the recovery is likely to be a very drawn-out affair, one made more protracted by the events of the weekend.
Financial crises do usually end with a bang, with some large institution going under or needing to be rescued. Many of us thought that the rescue a week earlier of Freddie Mac and Fanny Mae, the twin giant US home funding institutions, was the seismic event that signalled the turning point. Since the scale of that rescue was vastly larger than the events of the weekend, that is in a sense true. Lehman Brothers is only the fourth largest US investment bank and it had had some wobbles in the past. Nevertheless the aftershocks of the weekend, not just Lehman but also the sale of Merrill Lynch and the continuing plight of the largest US insurer, AIG, are very damaging.
But how bad is bad? From the narrow perspective of the world's share markets, it could have been worse. Shares have fallen on average by 3 to 4 per cent, so a bad day but not a wipe-out on the scale of Black Monday in 1987. The judgement by the US authorities that letting Lehman go did not pose a systemic risk – that is, a risk to the stability of the entire financial system – looks right. The markets could unravel further in the coming weeks and there may well be more casualties. It is horrible for the individuals caught up in any financial disaster but it would be even more horrible were this to go on and wreck an already fragile world economy. Mercifully that does not look likely.
The consequences of the weekend's events fall into three groups: the direct impact on the local economies; the indirect impact on the structure of the financial system; and the possible consequences for global growth. It is far too early to say anything definitive but here are some thoughts on each.
Lehman was (and still is, as some parts of the business are still trading) a big employer both in New York and London. Because both cities are heavily dependent on financial services, the local economies of each will suffer disproportionately. But there are many other aspects of financial services, for investment banking is quite a small segment of the total. So other parts of the business – fund management, general banking, the huge business of insurance, legal services and so on – will continue to thrive. Investment banking is a flashy bit of the business and it had perhaps grown beyond its natural size in recent years. But the froth will be off and some parts of the economy that depended on high-earners' discretionary spending will suffer.
Does this mean that the UK made a strategic error in relying so much on financial services? Hard to say; there is certainly a danger for any economy of having too many eggs in the same economic basket. But the business will recover, as it has in the past, and in the good years it is such a huge foreign earner (and contributor to taxes) that it more than pays its way. There is a bigger question as to whether the UK as a whole is wise to be so dependent on London, the South-east and East Anglia to finance the rest of the country. But that is a story for another day.
For the financial services industry the effects will last a decade, maybe longer. You can't uninvent the mass of complex financial instruments that the investment bankers have dreamt up in recent years but investors will be much more cautious about buying them. There will be a period, I guess, of anything up to three years, of back to basics, when no one will want to do anything that looks too clever. Everyone will want to know where risk lies: who actually loses if the borrower cannot pay.
The effect of this will be that it will be harder to borrow. We have already seen that happen in residential mortgages and it seems to be starting to happen in company borrowing. There is plenty of money around and not just in foreign sovereign wealth funds. Many of the people who have large cash balances will be looking to invest them, to buy assets at depressed prices. So there will be a self-correcting mechanism at work. The trouble is that, meanwhile, some businesses will find they have to cut back their investment not because the proposition is unsound but because they can't get the money.
That leads to the wider impact on the world economy. There is a clear economic cycle that lasts between eight and 10 years. Each cycle is slightly different in its character and timing but there are obvious similarities. Here in the UK you can compare the house price crash of the early 1990s with the present difficulties. But the fact that house prices now look as though they will fall by a similar amount does not mean that the British economy will suffer as much now as it did then. Though the debt burden is in some respects greater we have much lower interest rates and a more competitive exchange rate. In the early 1990s the UK was relatively badly hit by the world slowdown; this time we may scramble through in no worse shape than the other major economies.
In any case, viewed globally, there are a number of reasons to believe that this downturn will not be particularly serious. Overall demand is being maintained by Asia, in particular China, though it is slowing a little. Once this burst of inflation moves through the system, interest rates will come right down and that will help the heavily borrowed to pay back their debts. If however there were a general loss of confidence in the world banking system – and to be clear, that is most unlikely – then the whole engine of world trade and investment would be threatened.
There will inevitably be a period of slower growth ahead, maybe recession, and that will be a slog. But provided financial disruption does not lead to economic disruption, growth will resume and employment and living standards pick up again.