Will cheap money rescue the US economy – and at one remove, the world economy? And what does all this stuff that is flying around mean for us?
This is one of those times when you have to stand back and get some perspective. If you take seriously all those statements by the big-wigs about this being the worst financial crisis since the 1930s, you drive yourself round the twist. Those who make these alarmist assertions are, I suspect, doing so largely to play down their own failure of judgement as bankers or regulators.
If, on the other hand, as I shall argue, what is happening is well within the normal post-war parameters of banking crises and economic downturns, then to claim that what is happening is unprecedented is plain wrong.
It is also plain stupid, because when people who are in senior positions, or have just retired from them, go around talking up these terrors, the rest of us are inclined to feel fearful too. So, to be clear: yes, this is a serious financial crisis, such as occur from time to time; and yes, there will be a US economic downturn which will be transmitted to some extent to those of other developed countries, including this one. But no, this crisis is not more serious than those of the 1970s, 1980s and 1990s; and no, the downturn will not be more serious than those cyclical downturns either.
Indeed, the overall financial and economic condition is much less grave now than it was during the 1970s, when inflation was out of control, unemployment climbing, and the only weapon to combat inflation, higher interest rates, made the problem of unemployment worse.
Finance first. What we know is that bouts of market turbulence always last several months but they always eventually end. The signal of a turning point is usually a large financial institution needing to be rescued. It may be that Bear Stearns is big enough – Northern Rock wasn't – but there may be a bigger disaster out there. We simply cannot know, but we do know that any such collapse will occur in the next few months, maybe weeks, if it is going to happen at all.
Within a few months, the crisis will be past, and a slow convalescence will be established. But progress towards some sort of normality won't be a straight line. It will be a case of two steps forward, one step back and the backward steps will be unnerving. In any case, the new normality will be different from the old normality. Not only will credit conditions be tighter – would-be borrowers that are a bit iffy will find it harder to get credit – but the markets will be less complex. All the furious innovation of the past four or five years will be reversed, all that new alphabet soup of financial instruments, the CDOs, the SIVs, the ABCPs and so, on will disappear – or at least have a muted future.
The practical consequence for ordinary borrowers will be a more old-fashioned assessment of credit and risk. For example, people will be expected to put down a deposit before they get a mortgage. Money may become cheaper, but it will be harder to borrow. That, you might think, will be no bad thing.
It is against this background of a return to basics of banking that the US Federal Reserve is pumping out the money and cutting interest rates. There is a distinction here. It has to pump out the money – in the jargon, supply liquidity to the markets – because that is what central banks have to do to maintain some sort of stability. This is a classic, text-book central banking duty and no-one should criticise them for that. There are, however, legitimate questions about driving rates down, given that very low interest rates led to much of the problem of irresponsible lending. Loans were so cheap and plentiful that banks gave money to less and less creditworthy borrowers, hence the sub-prime debacle and the US housing crash.
Actually, given where we are now, having the US Federal Reserve drive down interest rates won't do much harm. But it will need to push them back up as soon as practicable. Meanwhile, do not expect cheap money to have a swift impact on the US economy. To see why, ask yourself a question. You want to buy the house round the corner and the bank will lend you the money at one per cent. But the price is falling every month and the next door one and the one beyond that has also come on to the market too. So do you buy? Well, eventually yes but you are in no hurry to do so. So eventually very low interest rates will boost house prices and through that, overall demand, but this could take a long time. Meanwhile, very low US interest rates deny holders of dollars and dollar assets a decent return. So the dollar falls and the dollar-denominated price of gold rises. So, more important, does the price of oil. Not so good.
To answer the first question above: eventually cheap money will revive the US economy, but this will take time and a sustained recovery will depend on other things, such as the inherent vibrancy of the US, the flexibility of its companies and their workforces, etc. The precedent of Japan in the 1990s is discouraging, for very cheap money failed to pull it out of stagnation. But it didn't have the flexibility of the US.
This time, the rest of the world economy will also face come sort of slowdown. You cannot flip out a calculator and say which other countries will be hardest hit and which will escape more or less unscathed. It would be nice if you could, but we don't know enough about the way the world economy links together to be able to say. We know that financial market disruption usually leads to disruption in the real economy. We know that flexible economies cope with downturns better than inflexible ones. Countries with a strong fiscal position have more chance of offsetting any downturn than those with a weak one. And, of course, at a time of high energy and raw material prices, there are obvious winners and losers. Oil exporters do well and importers do badly.
Beyond that, there is not a lot that can be said. My own best guess remains that this downturn will probably be more serious globally (and certainly more serious for the UK) than the post-2000 one, but not as serious globally or for the UK than the early 1980s or early 1990s. Were, however, the most vibrant of the developing country economies, that of China, to hit strong economic headwinds, that reasonably sanguine prospect could prove over-optimistic.
In the UK, we have the advantage of a flexible economy, an independent monetary policy, and an economy that at the moment still seems to be growing. But we are heavily dependent on financial services, an industry that will be hard hit; our consumers carry a heavy debt burden; our house prices are on some counts even more inflated than those of the US; and we have the highest government deficit relative to GDP of all the major economies.
Final point, and I don't think the news from New York changes this in any way: given the present momentum behind our economy, the problem year is not likely to be this one – it is 2009 that looks tougher.Reuse content