Leading Article: Low inflation, cheap money and endless growth never added up

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Stock markets indices are falling across the world. Hedge funds have collapsed. No one wants to lend to the buccaneers of the private equity industry any more. The central banks have been forced to pump liquidity into the system to stop commercial banks from going under as investors clamour to get their money back. But was ever a financial crisis so widely foreseen?

A huge amount of cheap money has been sloshing about in the financial markets in recent years thanks to historically low interest rates. Borrowers and lenders alike found their judgements impaired by the scale of the rewards on offer in a world where asset prices seemed to be for ever rising. Risk was mispriced. Too much debt was taken on. In short, people got greedy. This was a feature across the economy, from humble British borrowers taking on vast mortgages, to mighty private equity houses leveraging up to the hilt to take over blue-chip companies. Experts began to speak of a "new paradigm" of low inflation, cheap money and never-ending growth. When one hears such hubris it is usually the time to worry. And now the chickens are coming home to roost with a vengeance.

It began in the US where the "sub-prime" mortgage market - hefty housing loans to people with little or no regular income - began to flounder as the Federal Reserve raised interest rates and borrowers began to default on their repayments. Without this revenue coming in, the holders of this dodgy debt - the hedge funds, the banks - began to struggle to meet their other financial commitments. With the Bank of England and the European Central Bank following the Federal Reserve and raising interest rates, investors are now beginning to panic. They want to switch their holdings out of the thousands of complicated debt investment packages that have sprung up in recent years and put their cash into something safer, such as government bonds. The result is that credit is now all of a sudden much harder to come by. That means the takeover and buyout projects that have underpinned much of the stock markets' recent gains are in jeopardy. People are selling shares.

In truth, the crunch would have come a lot sooner were it not for China's growth as a manufacturing giant. That nation's ability to provide the world with electronics and clothing at cheap prices has kept global inflation down. The investment of Asian banks of their huge cash surpluses in Western currencies has also helped in that respect. Without these factors, interest rates would have risen in the West some time ago and exposed most of the dubious borrowing.

Looking back over the past seven years it is increasingly clear that the central banks of America and Europe pumped too much liquidity into the system - and bailed out previous bouts of market jitters too generously. Interest rates should have been higher. The question now is whether the economic correction will be sharp and short, or whether it will take on a momentum of its own as investor and consumer confidence collapses. Will, for instance, our own housing market go the same way as that of the US?

There is strong case to be made for calm. Despite the proliferation of poor lending, the fundamentals of the global economy remain good. The integration of China, India, Brazil, Russia and parts of Africa into the world trade system is powering growth.

But of course there will have to be changes too. Now interest rates are finally rising, a period of financial belt-tightening by companies, governments and consumers is inevitable. There will also be a purging of some of the cavalier capitalists of the City and Wall Street who did so much to encourage us to binge thoughtlessly on cheap credit. For that at least, we can be grateful for the return of those chickens.