Sunday, November 04, 2007
Still waiting for the credit crunch to bite
Posted by David Smith at 09:01 AM
Category: David Smith's other articles


Come Friday, it will be three months since the credit crisis broke out into the open.

Mervyn King, governor of the Bank of England, probably remembers it well. On August 8 he was assuring journalists there was no international financial crisis. The following day, August 9, all hell broke loose. The French bank BNP Paribas suspended three funds, the European Central Bank pumped in €94 billion (£66 billion) of liquidity and the Federal Reserve joined in with $24 billion (£12 billion) of its own. The Dow dropped by nearly 400 points. If it wasn’t a crisis it was a fair imitation of one.

A lot of water has flowed under the bridge in three months. Nerves remain on edge, as last week’s wave of selling for American bank shares showed. We had, indeed still have, Northern Rock propped up by £23 billion from the Bank. Some top bankers have fallen on their swords or been pushed onto them. Stan O’Neal, chairman and chief executive of Merrill Lynch, is on his way to an early but lucrative retirement.

The Bank, the Financial Services Authority and the Treasury all faced criticism, and the tripartite system for ensuring Britain’s financial stability was found seriously wanting.

But how much more do we know about the economic impact of the credit crisis than three months ago? As Kate Barker of the monetary policy committee (MPC) put it on a visit to the tomato growers of Guernsey: “We are asking ourselves if things are so different from August.”

It is a question worth asking. Charlie Bean, the Bank’s chief economist, gave a speech last week listing several ways in which the credit crisis could affect growth.

They include a cut in the supply of funds for new loans as banks find they cannot securitise such loans in the markets. This may be coupled with a rise in the interest rates banks have to charge borrowers because some risks they previously offloaded now remain on their balance sheets.

Taking these loans back onto balance sheets will, in turn, result in a deterioration of capital ratios, again pushing banks towards reducing credit supply. Finally, banks will be cautious about what they will accept as collateral from borrowers, building additional margins for falling asset prices.

There are some important offsetting effects. The fact the Fed has reduced interest rates and the Bank at the very least is no longer expected to raise them has brought down some interest rates in the economy, notably those linked directly to swap rates like fixed-rate mortgages. But the net impact is likely to be that the supply of credit will be reduced, while its price will be higher.

Bean’s conclusion, though, was cautious. “It is difficult to assess with any degree of precision the impact on the economy of the recent developments in financial markets,” he said. He also emphasised the robustness of the UK and global economies. Britain’s gross domestic product has grown at an above-trend quarterly rate of 0.7% or 0.8% for the past seven quarters, and is currently showing a 3.3% annual growth rate.

Some of the surveys for manufacturing, retail spending and consumer confidence suggest weaker growth is on the way. But the Bank was expecting a slowdown anyway. The Nationwide reported a 1.1% rise in house prices last month.

There is a “bad news bias” about reporting of housing – look at how much coverage the Nationwide’s report of a 1.1% rise got in comparison with Hometrack’s 0.1% fall – but it still looks like a soft landing.

This is a big moment for the Bank. Bean and his colleagues have been working on the November inflation report. Realistically, if the MPC is going to act to head off a downturn next year induced by the credit crisis they have to start this week. Do they have enough to go on?

The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, believes definitely not. I had the privilege of sitting in on the shadow MPC’s deliberations. The tone of its meeting was, if not “crisis, what crisis?”, at least that the Bank should be extremely wary of responding.

Anne Sibert of Birkbeck College summed up the mood when she said: “The economy is recording good growth and, in the absence of the credit crunch, monetary policy was correct. The credit crunch will be a blip and there should be no change in interest rates.”

So the shadow MPC voted 9-0 to leave interest rates on hold at 5.75%. Though two members thought the credit crisis would have significant, if delayed, effects, most were not even prepared to give it the benefit of the doubt. They were mindful of previous episodes when there appeared to be a serious financial threat, as in autumn 1998, followed by a strong rebound in growth. Many remain troubled by continued strong growth in broad money, M4.

John Greenwood, chief economist at Invesco Asset Management, said the impact of the credit crisis would be short-lived and that there were already signs of normalisation in markets. Trevor Williams of Lloyds Bank, close to the sharp end, said it was too soon to know whether the crisis/crunch would have “any discernible negative impact on economic activity”.

The actual MPC may yet see things differently as it sits down this week, though the signals its members have been giving would certainly not point to an early cut in rates. One point of discussion last month was whether an “insurance” rate cut might be possible, in case the credit crisis turns out to be more serious in its impact. The conclusion then was that such a cut is quite hard to explain; the markets tend to view rate cuts like London buses – when one comes they expect several more in quick succession.

I agree with the shadow MPC that this is not the time for a rate cut, and I would expect the actual MPC to concur, barring a rout in the stock markets in the coming days. After all, the first question to follow a cut would be: What do they know that we don’t know?

PS: Arms twisted behind his back by Downing Street, Alistair Darling appears ready to rein back on his much-criticised shake-up in capital-gains tax (CGT). The burden of the increase in CGT on business assets from 10% to 18% fell heavily on small entrepreneurs selling up to retire, and the plan is to give them up to £100,000 in tax relief.

That does not go far enough for many critics, but where did he get the idea from? Let me cast aside false modesty and quote from here two weeks ago: “Is there a way out? . . . John Whiting of Price Waterhouse Coopers suggests the Treasury could reinstate the retirement relief that was part of the original post1965 CGT system, shielding business owners who sell up to retire. Something has to give.”

Meanwhile, my “freakonomics” search for films with real-life consequences continues. Several readers blame Jaws for the decline in popularity of the traditional seaside holiday. Colin Hayes suggests Britain did not take India seriously because of Peter Sellers’s portrayal of the comic Indian in the 1960 film The Millionairess – Goodness Gracious Me.

On a different note, I like the idea that the decline in West Indian cricket was due to the arrival of satellite television, and exposure of kids to televised American basketball.

Keep them coming.

From The Sunday Times, November 4 2007


I suspect they know a great many things that we do not, but they don't wish to reveal them unless they are forced to! OTOH given their musings and the handling of NRK, one wonders just how close these guys really are to the banking system compared to, say, the Fed and its own banking system. If Bernanke is too much of an academic then surely Mervyn is even worse, although not burdened by an unhealthy obsession with the great depression, at least.

Merrills had a HUGE write-down last week (possibly after you wrote this piece) and there are certainly others to follow. The big investment banks have "marked to model" their portfolios hoping for a recovery in the credit markets before their year-end accounts are due and they have to get the auditors in. Their quarterly accounts are unaudited but their year-end ones are, and the auditors have been making noises about not allowing the "mark to model" fantasy-land to continue any longer. Some have talked about marking holdings to the ABX (which would mean catastrophic losses). Merrills are just the first to blink. Citi are having a meeting about this today, and GS and others are sure to follow. All of these banks have their year end coming up in the next couple of months. Only then will we really find out just how bad these losses are. I suspect once we do, the appetite for lending/credit will be significantly damaged.

ABX charts:

Posted by: Minh at November 4, 2007 06:22 PM

No, I was aware of the writedowns but the point still stands - we're still waiting for decisive evidence of a significant UK economic impact. I'm not saying it won't happen but so far it is hard to see in the data.

Posted by: David Smith at November 4, 2007 08:09 PM
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