When the Chancellor of the Exchequer said last month that the UK faced its worst economic crisis for 60 years, he was widely criticised for being too pessimistic. After the events of the past 36 hours, it could be argued that he was not being pessimistic enough.
Add the bankruptcy of 158-year-old Lehman Brothers and the fire-sale of Merrill Lynch to the demise of Bear Stearns in March, then three of the top five names in American investment banking have now bitten the dust. One of the world's largest insurance companies, AIG, is also reported to be in trouble. The global credit crisis has taken on a whole new dimension.
Given that the immediate causes of this crisis are now well known – irresponsible lending by financial institutions, and the creation of ever-more complex credit instruments that concealed the true extent of banks' exposure – there are only three questions that are worth asking at this juncture. Is this the worst it is going to get? What can be done in the short term to mitigate the effects? And what measures can be taken to prevent any recurrence?
The news eight days ago that the US administration had given up hope of solving the mortgage crisis by free market means and taken the country's largest mortgage lenders into full public ownership ended weeks of mounting uncertainty. It seemed also to offer reassurance to borrowers that, when such large lenders were in danger, the government would have no choice but to step in. That Lehmans has been forced to seek Chapter 11 protection in the United States and to call in the administrators over here induced a new and immediate chill. The simultaneous sale of Merrill Lynch – regarded as the next most vulnerable bank – was clearly timed to pre-empt any possible domino effect. Even so, stock markets around the world fell by between 3 and 5 percentage points yesterday.
How far other banks and companies might still be contaminated by bad debt, not just in the US but in Britain and other European countries, is still unknown. But it would be foolish for shareholders and employees not to be prepared for more bad news. Those queues outside branches of Northern Rock might seem ancient history now, but it is now evident how much closer they were to the beginning of this crisis than to its end. And until the surviving banks regain confidence in each other's creditworthiness, the stagnation in lending will continue.
The message from the failure of Lehman Brothers is that the principle of moral hazard is back, or – and it hardly matters which – that there are limits to the depth of even the US Treasury's purse. There is now no reason for any bank to delay disclosing its liabilities in the hope of a bail-out. But there is no guarantee either that the pain will end here. It is lack of confidence and credibility, quite as much as any lack of money, that keeps this crisis going.
This makes mitigating the effects in the short-term that much harder. The British mortgage market has thawed a little for home-buyers with adequate liquidity and, with prices falling, first-time buyers would probably be well advised to stay out of the market for the moment. But it is businesses that face the most acute difficulties from the reluctance of banks to lend: the small companies that would, under normal circumstances, be regarded as credit-worthy risk being deprived of their life-blood along with the improvident.
Nor is it only the staff of failed banks who will suffer: the knock-on effects have still to make themselves felt in almost every sector of the economy. Higher, perhaps much higher, unemployment looks inevitable. So far, the Bank of England has – rightly – stopped short of following the Federal Reserve and reducing interest rates. But there may come a time when the pain starts to outweigh the gain.
As for trying to minimise the prospects of anything remotely similar happening again, it is clear that the regulatory regimes that failed to detect the dangers from such complex and opaque credit arrangements need a complete and urgent overhaul. Transparency and simple lines of accountability in banking must be priorities. But the temptation to fight the last war in too much fine detail should be resisted.
It may be hard to recall in present circumstances, but the flexibility that accompanied the globalisation of the past 20 years fostered more that was good than bad. It facilitated growth that brought higher living standards almost everywhere, improving the lives of ordinary people from India and China to the backwoods of America. However strict any new regulatory regime, there should be no flight to protectionism. Today's sclerosis will not be cured by regulation that simply exchanges new blockages for old.