Stephen King: You can't buy confidence when the economy is in a state of collapse

Monday 12 January 2009 01:00

'In the bleak midwinter ... " Britain's weather may be distinctly chilly at the moment, but its economic climate is a lot frostier. And unlike the weather, there's no escape. Economically, it's hard to find sunnier climes elsewhere in the world.

In November, UK manufacturing production fell 2.9 per cent compared with October, leaving output down 7.4 per cent compared with its level in November 2007. Manufacturing losses were not, however, confined to Britain. German manufacturing output fell 3.5 per cent on the month while in France, production fell 3.1 per cent.

These are shocking numbers (although not quite so bad as the decline of over 8 per cent in Japanese output in November). They serve to emphasise the global nature of the downswing. They also, sadly, suggest we're about to see a major worldwide rise in unemployment. The US is leading the way, underlined by Friday's news that its unemployment rate rose to 7.2 per cent in December. Overall in 2008, America lost more jobs than in any year since 1945.

Even 18 months ago, none of this seemed very likely, at least as far as economic forecasters were concerned. Their optimistic views were based on a number of simple observations.

There might have been a housing and sub-prime crisis, but there was no reason to believe companies, with their relatively low levels of debt, would find themselves in trouble.

Also, while there were a few difficulties in the financial system, the Long Term Capital Management (LTCM) crisis back in 1998 demonstrated that the authorities apparently knew what to do in times of financial stress. And even if the US and parts of Europe might suffer temporarily from a housing-related pause in economic activity, the world economy as a whole would still be able to motor along, driven by new engines of economic growth supplied by, among others, China and India.

If all else failed, the Federal Reserve would be able to cut interest rates, as it had done in the early years of the decade, to reinvigorate the US and hence the world economies.

In hindsight, these arguments were a triumph of naïve optimism over a grim and increasingly harsh economic reality. What went wrong? The answer, I think, rel ates to a massive loss of confidence in all aspects of the financial system. The crisis in the US housing market was merely a catalyst. It demonstrated that so-called financial stores of value – mortgage-backed securities, high-yielding corporate bonds and the like – were often not worth the paper they were written on. Their value was related not so much to economic fundamentals but rather to a collective act of faith – in banks, ratings agencies, in institutional investors, in hedge funds, in regulators and, ultimately, in the ability of financial markets to deliver higher levels of economic wealth.

Economic progress began to depend on these acts of faith. Bank lending accelerated not so much because banks were awash with deposits – they often weren't – but instead because banks were able to package up loans and sell them to pension funds, insurance companies and the like. They, in turn, were happy to buy these securitised bonds because the yields were high enough to keep their underlying investors – the likes of you and me – happy in the belief that the financial industry was capable of satisfying our desire for wealth.

The results of this process have been disastrous not so much because the value of these securities has tumbled – financial markets crash all-too-frequently – but, rather, because our banking system came to depend on the willingness of investors to hold these securities. Bank loans were no longer linked to the careful accumulation of bank deposits: instead, they became dependent on market speculation. As financial boom turned to bust, so bank lending collapsed.

Everything else follows. This is not an LTCM moment because, this time, the financial system as a whole has imploded. We're no longer talking about the antics of one particularly hubristic hedge fund but, instead, about hubris across the financial system as a whole. Rate cuts don't work because they only affect the price of credit. This crisis is much more about the quantity of credit. Emerging economies haven't been able to decouple from the West because they have become increasingly dependent on credit extended to them from the western banking system: that credit is now drying up. And companies are in trouble through no fault of their own: they've been caught in a pincer movement associated with collapsing household spending and a drying up of working capital, the financial lifeblood of the corporate world.

Even worse, the public now recognises that time is, in a conventional sense, running out. US official interest rates have already fallen to zero. The UK bank rate is down to 1.5 per cent, the lowest in the Bank of England's 315-year history. Japanese interest rates have been languishing at these sorts of levels for well over a decade. If economies continue to soften, there is, it seems, no further conventional ammunition left with which to fight the massed forces of recession.

A loss of faith in both financial assets and conventional policy is a toxic problem. People respond by hoarding cash, by delaying their consumption, by simply "waiting and seeing". Confidence is held up by gossamer threads: break those threads and all sorts of horrible outcomes suddenly become possible.

As things stand, 2009 is likely to be the first year in decades where economic activity in the world as a whole will shrink. Unlike the other major economic crises of the last 60 years (in the mid-1970s and the early-1980s) this is a story not about inflation but, instead, about a systemic failure of the world's financial system accompanied by deflationary undertones. It is now vital that policymakers spell out clearly a plan of action and explain to an increasingly-sceptical public how the plan is likely to work.

Understandably, all eyes are now on the US. President-elect Barack Obama is already dropping plenty of hints about a sizeable fiscal package, perhaps as big as $1trn over the next two years. The Federal Reserve has already headed down the unconventional monetary path, buying up all sorts of assets and putting them on its own balance sheet.

I have no doubt these actions are appropriate and necessary. Whether they will work, though, crucially depends on a recovery in financial confidence. While there have been some encouraging signs here and there – credit spreads have narrowed a touch and equity markets have rebounded from the lows late last year – the best we can probably hope for is a world economy which slowly limps away from what is fast becoming the worst economic downswing since the Great Depression.

Stephen King is managing director of economics at HSBC

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