Sunday, September 21, 2008
Welcome to the new age of austerity
Posted by David Smith at 09:01 AM
Category: David Smith's other articles


In America, it seems, the cycle comes round every two decades. One of the first acts of George Bush Sr when he became president in 1989 was to announce a rescue of America’s mortgage lenders, the savings and loans institutions.

The blueprint for that rescue, which set up a fund, the Resolution Trust Corporation (RTC), to bail out irresponsible lenders, was dusted off last week by his son’s Treasury secretary, Hank Paulson.

The names are different and so is the scale. “RTC II” - unveiled at the height of last week’s turbulence - is intended to rescue the US financial system. If it works, as its predecessor did, it will be seen as a triumph of pragmatism - a Republican government again showing its willingness to intervene when the market fails.

If it does not, then the comparisons will be to another US president and era: Herbert Hoover and the Great Depression.

Even hardened City professionals were shaken by the scale of the carnage last week as the world’s financial system teetered on the brink.

One economist, Ian Shepherdson of the firm High Frequency Economics, likened it to a plague of locusts cutting a swathe through the financial system. After devouring one target, they moved on to the next.

The swarm quickly crossed the Atlantic. Had it succeeded in forcing the bankruptcy or nationalisation of HBOS - Halifax Bank of Scotland - then not only would it have moved on to other UK banks but the economic consequences would have been disastrous.

Banks are not like other businesses. The closure of a big car factory hits its workers and suppliers; the failure of any bank of significant size hits the whole economy.

In recent months much of the attention of the Treasury, the Bank of England and the Financial Services Authority, the City regulator, and of their overseas counterparts, has been on getting the banking system through the crisis. Saving the system had to come first; saving the economy would follow.

How has it come to this, and what will be the consequences? Vince Cable, the Liberal Democrat Treasury spokesman, suggested at his party conference last week that this was a problem made in Britain. “New Labour incubated a culture of financial gambling with other people’s money which has contributed to the collapse of trust in financial institutions,” he said. “It also bred a dangerous dependence on debt.”

Debt has increased and the housing market is in trouble, but on their own they could not have caused the kind of problems that HBOS ran into last week. Britain’s mortgage lenders survived the housing crash of the early 1990s.

Most people know the crisis resulted from dodgy “sub-prime” mortgage loans to low-income borrowers in America. Even these loans, however, would not have been enough on their own to cause the difficulties. Direct losses on them, after repossessed properties are sold off, will probably be no more than $200 billion (£109 billion). That is a lot of money, but small in relation to the $14.3 trillion US economy.

A trillion dollars ($1,000 billion) is serious money. That is the likely extent of the losses on the so-called derivatives linked to sub-prime mortgages. These complicated financial instruments, created by investment banks using sub-prime mortgages as a base, may have generated losses of five times those on the original loans.

The reason this has come to a head can be found in a theory developed by George Akerlof, the American economist. Nearly 40 years ago he published a paper called The Market for Lemons. A lemon is something that people think is going to be trouble and, as a result, are extremely wary about buying.

Akerlof took the example of used cars. Why would anybody sell an apparently faultless car? Perhaps because they knew that the gearbox was about to seize and the engine fall out. Such fears might be unfounded, but who would want to take that risk?

The result of what Akerlof called “asymmetry” of information - sellers know more than buyers - would be that the prices of all used cars, good and bad, would be pushed lower. Only if people had a guarantee that their fears were unfounded would they be prepared to pay a fair price.

In the past few days we have seen an extreme version of Akerlof’s theory at work. It started, bizarrely, with the US government’s rescue of Fannie Mae and Freddie Mac, the bulwarks of America’s mortgage market. After an initial period of calm, buyers of bank shares decided the institutions that were most exposed to the derivative instruments linked to that market were “lemons”.

The biggest lemons, it seemed, were the Wall Street investment banks. They, unlike the big commercial banks, did not have the capital, the financial muscle, to fall back on. Not only did investors take fright but so did everybody dealing with the banks, including other banks. Investment banks rely on being able to deal with other institutions. When they can’t, they are sunk.

Lehman Brothers was sunk last weekend and Merrill Lynch lost its battle to survive as an independent bank. HBOS was seen as the biggest lemon in Britain because of its reliance on the City’s “wholesale”, or inter-bank, money markets and its exposure to falling house prices, as a result of being the country’s biggest mortgage lender.

When nobody will buy a used car at a decent price, the response of dealers is to offer a guarantee. When confidence in the banking system is shattered, only governments can offer such a guarantee.

That was the thinking behind RTC II, sketched out by Paulson on Thursday night. Although the details are still being hammered out, the outlines are clear. The US government will set up a pot worth $700 billion to buy banks’ failed assets and provide guarantees to money market funds.

Will it work? George Magnus, the veteran international economist at UBS, the Swiss bank, sees it as the “beginning of the end” of the financial turmoil. World stock markets appeared to agree and shares leapt on Friday. But Magnus also warned that we were nowhere near the end of the process in which the banks would “deleverage” - cut back on lending - and in which assets, including houses, would carry on falling in price.

America’s actions may have stopped the panic but they do not mean that the heady days before the credit crisis broke in August last year will return.

When banks failed on a grand scale in the 1930s - about a third of US banks folded - the Great Depression ensued. The consequences of the banks reining back this time may be something like the “new austerity”, a long period in which the economy grows weakly if at all. Even before the events of the past few days, economists were gloomy about the outlook, predicting 1.2% growth this year and just 0.5% next. Those numbers could prove optimistic.

It will mean higher unemployment, far beyond the direct job losses resulting from the City’s woes and the Lloyds-HBOS merger. The claimant count, now 900,000, rose by 32,500 last month. At that rate it will hit 1.4m at the end of 2009. The monthly rises may get worse over the winter. For Alistair Darling, faced this week with the most testing party conference speech for a chancellor in years, an uncomfortable job will grow even stickier.

Next month he will publish his prebudget report and be forced to cut his growth projections sharply, while acknowledging that the government has been forced into tens of billions of extra borrowing. In March he said public borrowing would drop to £38 billion next year. Instead, say researchers at the Centre for Economics and Business Research and Capital Economics, it will rise to between £90 billion and £100 billion over the next two years.

Economists say that Darling, or his successor, will have no option but to raise taxes or cut public spending. The National Institute of Economic and Social Research says he will have the choice between a 3% cut in public spending and raising taxes by the equivalent of 5p in the pound. The effects of current events will last for five to six years, it says.

“There is a choice to be made between sticking to present spending plans and raising taxes, or changing those plans,” said Ray Barrell, senior research fellow at the institute. “The world is a different place.”

Beyond the immediate crisis, the prospect is of only a slow economic recovery.The banks will remember this bloodletting and panic for years.

That will make them more reluctant to lend than we have been used to in the past 15 years. Lending feast has been replaced by borrowing famine, and that famine will last.

People in Britain have been accustomed to easy money. Over the past year they have seen the credit taps being turned down and it has hurt. Last week’s crisis tells us that is not going to change for a long time. Combine that with the likelihood of higher taxes and slower growth in government spending and it does not look like a comfortable picture. Welcome to the new austerity.

From The Sunday Times, September 21 2008