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COMMENT & ANALYSIS

Analysis

An economy undermined? Experts assess the real costs of a financial crisis

By Chris Giles

Published: March 18 2008 19:01 | Last updated: March 18 2008 19:01

Chaos has taken over financial markets. Small European banks and a large US investment bank have succumbed. Trust is evaporating and money ceasing to flow. Economic pessimism is on the rise.

But apart from the still relatively small number of US households facing foreclosure, the fallout for companies and households around the world has thus far been limited.

Half a year into the credit squeeze, unemployment in the 30 rich countries represented at the Organisation for Economic Co-operation and Development stood at 5.5 per cent, 0.3 percentage points lower than a year earlier. Even in the US, the proportion out of work has risen only 0.3 percentage points in the 12 months to February. Last year was simply a stunning one for economic growth, rounding off the best global four-year period for more than 30 years. The International Monetary Fund’s latest estimate puts world economic expansion at 4.9 per cent.

In short, the global economy is in the middle of a phoney war. The future appears bleak but the present still looks relatively rosy.

There was no mistaking the concerns of international financial institutions on Monday. Dominique Strauss-Kahn, the managing director of the IMF, told a conference in Paris: “We clearly face a situation in which the risks to economic growth are clearly more and more serious.” Angel Gurría, the OECD secretary-general, said the organisation would lower its forecasts for the European and US economies on Wednesday.

But if anything like the latest forecasts are achieved – world economic growth of 4.1 per cent in 2008, according to the IMF’s January forecast update – the credit crisis will have proved not to be the cataclysmic event that Wall Street fears. For those fears to be realised the global economy needs to descend into two interlinked vicious circles.

The first has the ugly name of a “negative feedback loop” between the financial markets and the real economy. Paul Tucker, the head of markets at the Bank of England, warned in December: “We must try to avoid a vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other.” The fear is that banks will transmit their pain to borrowers with higher interest rates that will, in turn, increase delinquency rates and put further strain on the banks.

The second debt-deflation spiral is well known to the Japanese, where the economy is still struggling to emerge from the 1990s crisis of increased savings leading to falling prices, which raised the burden of debt and induced households to save even more.

Hard evidence to date of either of these nasty conditions taking hold is scant. Surveys of credit conditions in the eurozone, the US and the UK all show banks are restricting credit to households and intend to tighten the screws further, but bank lending is yet to fall significantly. Creditworthy companies’ borrowing costs have not risen much, nor has the cost of mortgages.

Granted, looser monetary policy in the US and to a lesser degree in the UK has not been effective in reducing the cost of borrowing. But neither has the credit crisis made loans prohibitively expensive.

As Erik Nielsen, chief European economist at Goldman Sachs, points out, it is “difficult to identify whether a vicious circle is happening yet”, as part of banks’ current lending represents the enforced bailing-out of off-balance sheet vehicles.

But fear and risk is certainly present. Kenneth Rogoff, a professor at Harvard University and a former chief economist of the IMF, says: “The credit crunch is rapidly morphing into a credit collapse. The same factors that propelled the US housing bubble are now spinning in reverse, and there is as yet no bottom in sight”.

Michael Hume, chief European economist of Lehman Brothers, says that although material evidence of tightening credit standards in the real economy is still weak, “banks appear to be restricting credit to each other and non-bank financial institutions, which is leading to deleveraging within the financial system”. This, he adds, is hitting banks’ balance sheets and threatens to start a downward spiral “that may be hard to break”.

Sir Howard Davies, director of the London School of Economics and a non-executive director of Morgan Stanley, thinks that even when the worst point in the credit crisis passes, “surviving banks will have experienced a chastening shock and will continue to give priority to restoring their capital buffers, so credit will be restricted for some time, with serious consequences for the US economy in particular”.

Fears are also spreading that European and Asian banks might not be immune, particularly if the recent falls in the market value of high-quality US mortgage debt continue. They bought much more of this debt than subprime mortgage assets.

The fear of a debt-deflation spiral similar to Japan’s in the 1990s is driving US monetary policy at the moment. The Federal Reserve does not believe both economic growth and inflation are poised to turn negative, but its aggressive action to lower interest rates represents its view that everything must be done to avoid that scenario.

With house prices already falling in the US and slowing or stagnant in other leading economies, commercial property appearing fragile on both sides of the Atlantic and rapid falls in the dollar reducing the value of US-based assets, the chances of a global fall in wealth exacerbating any slowdown through weaker consumer spending and investment are growing.

A third force depressing advanced economies is rising inflation, pushed upwards by high oil, food and commodity prices. Price pressures – with headline rates at 4 per cent in the US, 3.3 per cent in the eurozone and 2.5 per cent in the UK – limit the scope for central bankers to throw money at the global slowdown for fear of reigniting an inflation problem thought to have been defeated in the mid-1980s.

The Fed, on the other hand – being at the centre of the credit crisis – has worried more about the risk of financial meltdown than rising inflation. Professor Rogoff believes the US focus solely on lowering interest rates is a mistake and it “is going to experience years of elevated inflation at the end of this, with or without an epic recession”.

Other central bankers have had more leeway to fret about faster price rises, with survey evidence showing that consumers are beginning to think of higher inflation as normal.

Mervyn King, the governor of the Bank of England, was blunt in telling UK consumers last month that higher energy and food prices represent “a genuine reduction in our standard of living” and urging people to accept “that’s not something that we can offset by just demanding higher wages, because all that will do is lead to another round of higher prices”.

With all these warnings from officials and economists in the US and Europe, anyone would be forgiven for thinking the world economy is teetering at the edge of one or both vicious circles, with the added risk of a nasty dose of inflation. At the moment, however, that would be an exaggeration.

Julian Jessop of Capital Economics, the consultancy, notes: “The financial crisis is still largely contained to the US and some parts of western Europe, with little or no direct impact further east”.

Gerard Lyons, chief economist of Standard Chartered says: “The US is facing this vicious cycle, not the world.”

“Before one becomes overly pessimistic, the world economy’s boom in the last five years was not just driven by a credit binge in the US, but has reflected a fundamental shift driven by longer-term change.” He says that after a cyclical setback, which will hit those economies least insulated, “the structural change being seen on the ground around the world is set to continue”.

Julian Callow of Barclays Capital says that, with the troubles most likely to hit countries with high borrowing, those with current account surpluses, well-capitalised banking systems and commodity exports should perform well. He singles out Latin America, excluding Mexico, as an unlikely beacon of stability, precisely because of its history of crisis. “Latin American countries’ historic experience of crises means they have generated various war chests, including well-capitalised banking sectors.”

Fred Bergsten, director of the Peterson Institute for International Economics, sees the continued momentum in the emerging Asian economies and China, in particular, as a source of optimism for the US in troubled times. “There are still no signs of significant spillover from the United States to China, India or most of these countries,” he argues, adding: “Their continued strength will generate a significant degree of ‘reverse coupling’, limiting to an important extent the degree of the US slowdown.”

Strong growth, even if it is slower, in emerging economies will not come to the rescue of the US, given its home-grown problems. Martin Feldstein, a professor at Harvard University and president of the US National Bureau of Economic Research, believes the economy is already in recession and faces potentially the most damaging period since the second world war. But it has the potential to limit the downside risks and the spillover to economies in the rest of the world.

While Goldman Sachs’ calculation that, on market exchange rates, the eurozone is now the world’s largest economy is purely a symbolic fact, it serves to highlight the fallacy in believing the world cannot survive without a strong US economy. But the outlook is terribly uncertain and, for the moment, forecasts made one week are liable to be torn up the next.

Few at the moment dare to predict how far US house prices will fall; whether defaults on commercial property, credit cards debt and car loans will pick up, deepening the pain for banks; how far banks will restrict credit to good risks to shore up their balance sheets; whether the falling dollar will spread fear through global financial markets; or whether house prices in other economies will fall as rapidly as in the US.

With such fundamental uncertainty, the underlying outlook for the global economy remains almost impossible to fathom. Prospects are deteriorating. The world economy will slow next year and advanced countries will be at the sharp end.

For the US, the question is how hard the landing will be; for Europe and Japan, it is whether the landing will be hard or soft; and, for many emerging economies, there may still be no landing at all.

Deleveraging will take its toll – but on whom is unclear

When Jan Hatzius, chief US economist at Goldman Sachs, met clients in London recently, he presented a striking chart, write Krishna Guha and Gillian Tett.

This predicted that major banks and brokers would suffer about $200bn (£99bn, €127bn) in subprime-linked losses over the coming months. However, the impact of these losses on bank lending could be much greater. Mr Hatzius suspected that a $200bn subprime loss would cut bank capital by 12 per cent; if banks then shrank their balance sheets by 12 per cent, the implied reduction in overall lending – due to leverage – would total $2,300bn.

Mr Hatzius is not alone in these calculations: economists such as Hyun Song Shin of Princeton and Anil Kashyap of the University of Chicago collaborated with him to reach similar conclusions.

Their work is consistent with the concept of a “financial accelerator” – put forward by Ben Bernanke, the chairman of the Federal Reserve, when he was an academic. This theory holds that when a credit cycle turns, losses to banks and falls in the value of the collateral underpinning their loans can cause banks to pull back on lending, amplifying an economic downturn.

However, amid the number-crunching there are two crucial uncertainties.

One is whether the banks will manage to plug their current capital holes with fresh equity injections – from sovereign wealth funds or any other source. Another, equally important, uncertainty is which borrowers will take the hit.

Banks have typically responded to balance-sheet pressure in the past by slashing lending to companies or consumers. But this decade’s credit bubble has been characterised by spectacular growth in lending to other financial institutions, such as hedge funds. As a result, it is in the financial sector – not the mainstream corporate world – where much excess leverage now lies.

Banks may deal with balance sheet problems by cutting exposure to financial borrowers first – meaning, as Mr Hatzius says, that the real “lending constraints may happen within the financial world”. If so, the credit crunch woes may be felt most in hedge fund centres such as London’s Mayfair or Connecticut rather than places such Manchester or Colorado that are tied to the “real” economy.

Until quite recently, some policymakers believed that this meant the “real” economic impact of the credit crunch might be less dramatic than feared. However, the idea that hedge fund pain can be “ring-fenced” from the rest of the economy is starting to crumble.

It matters enormously which hedge funds banks cut lending to. If they pull back on lending to commodity funds, for instance, the impact on the economy could be minimal. But if they pull back on lending to funds with large holdings of mortgage-backed securities, the effect on the economy will be magnified.

Most experts now believe that an implosion in the financial world will end up hurting real-economy borrowers.

In practice, it is hard to tell whether this is playing out yet, since banks do not divulge timely details of their lending (or lack of it). But what is crystal clear is that the pressures on bank balance sheets are growing.

Banks are finding it harder to fund themselves. The credit default swap spread for many banks have tripled in the past four months to levels well above the spreads commanded on mainstream companies.

This implies that it now costs banks more to raise funds than their corporate clients – making it uneconomic for banks to engage in some of their core lending activities.

“High funding costs are likely to persist.” says Huw Van Steemis, an analyst at Morgan Stanley, who points out that this pattern has not been seen for almost two decades.

The bottom line? A big pull-back in bank credit may be on its way – unless investors or governments put more capital into the financial system.

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