Hamish McRae: So will anything shift the economic gloom?

Confidence will not suddenly snap back. Trust can only be rebuilt gradually
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The Independent Online


It is a classic financial crash. Another week of mayhem in the markets, another week of despair among bankers, another week of rising concern for the rest of us. The world's monetary powers sought to reassert their authority last week by cutting interest rates, while individual governments, in particular our own one, continued to unwrap national rescue packages. Their aim was to restore confidence – and they failed.

They may well continue to fail in the weeks ahead. Something will emerge from the Group of Seven meeting in Washington but, given the mood of the markets, it is unlikely that any initiative that is announced in the next few days will be sufficient to shift the gloom. There have been too many missteps by the authorities in recent weeks, in particular the US failure to support Lehman Brothers, for statements by political leaders to have much effect. In any case US policy will be unclear until a new administration is formed.

There are various measures of the present financial stress. The most obvious one inevitably is what has happened to share markets, where the tone has taken on something of the 1974-75 market crash, which for the UK still remains the worst since the 1930s. But there is another measure of stress, less obvious but more insidious, which is the gap between the official interest rates set by the central banks and the rates on the wholesale money market. The central banks duly cut their rates this week but money market rates failed to decline. Actually it is worse than that. The fact that the rates failed to decline does not simply mean that money for the banks remains expensive. It means that the markets effectively shut.

Shut? Well, almost. Imagine a shop that you can walk into and has eggs on the shelf – but when you try to buy a dozen the shop says, 'well you can have just one egg as we have to keep the rest for our other customers'. So there is a price but there is no volume. If banks cannot rely on the money markets to borrow funds when they are short they have to restrict their own lending. We have seen the effect of a mortgage famine on the housing market and the more general loans famine is just starting to spread to the wider business world, with smaller businesses in the front line.

So all the efforts to rebuild confidence in the banks, including, in the case of the UK, the access to £50bn of capital from the Government should they need it, and the hundreds of billions pumped into the markets by the Bank of England, have not yet revived the money markets. It is that that has led to the share market crash. If companies cannot fund their business, they have to cut back and, if they cut back, that will lead to a recession. The markets, in their incoherent but brutal way, are saying recession is now certain.

That does not mean they will be proved right, for they are the self-same markets that, even back in May, were signalling that, though there might be a downturn next year, for the major economies actually to shrink would be most unlikely. There would be no more reason to believe they are right now than that they were right then were it not for one thing. That is that share markets not only signal what might happen to the world economy; they also affect it.

The practical issue facing many companies at the moment is how to manage their debts. If they have plenty of spare cash they are fine – unless they have followed the practice of our local authorities and put it into Icelandic banks. Fortunately most finance managers seem to be more prudent than local authority treasurers. But if a company has bank debt that is coming up for renewal that may be difficult. Normally companies would have other sources of capital. They could go to the stock market, private equity houses, whatever. But if the markets are bombed out, as they are now, shareholders will be reluctant to stump up more funds. Private equity houses may be in even more trouble. So the fact that share markets have collapsed not only reflects the threats to the world economy; the collapses have become a threat in themselves.

So what will happen? There is a natural cycle to market panics and if this one follows the pattern of the past, there will be some pivotal moment, a moment of utter despair, and then they will bounce back quite swiftly. Unfortunately that does not mean they will recover all or even most of the ground that has been lost. They may bounce along in a pretty depressed state for some time and the longer they remain depressed, the greater the damage to the world economy. Given what has happened so far, a global downturn, perhaps on the scale of the early 1990s, does now seem the most likely outcome. The more incoherent the policy response, the more protracted the downturn.

The world economy is naturally resilient. All post-war recessions, even the really nasty ones of the 1970s, eventually came to an end and growth recovered. Though the policy-makers have no magic wand that can prevent a recession, they can and should have the more limited objective to prevent the financial crisis from inhibiting the real economy's power of recovery. That is why they have to support the banks, even if they feel bankers have been greedy and foolish. Blame and punishment can be handed out later; right now they have to stop the rot.

Assuming that the authorities are reasonably competent from now onwards, there is no reason to suppose that this downturn will be any more serious than that of a "normal" post-war cycle. Comparisons with the depression of the 1930s ignore the fact that the world economy then had been destroyed by the First World War and that international co-operation had been destroyed by the hatreds of its aftermath. By contrast the world has just experienced the greatest burst of prosperity that it has ever known and scaling back of that growth was inevitable. It has just happened in a much sharper and more troubling way than most people expected.

If this is indeed a "normal" cycle then there will be one or two difficult years before growth resumes. Confidence will not suddenly snap back. Trust can be rebuilt only gradually. Next year will be more difficult for the economy than this one. The important thing is to stop a financial panic becoming an economic one. It may already be too late.

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