Sunday, October 12, 2008
Time is running out for a global rescue
Posted by David Smith at 09:01 AM
Category: David Smith's other articles

For a time on Friday it seemed as though the end of financial civilisation was upon us. After huge falls in Asia, Europe and London, it appeared that Wall Street — which started the panic with a huge slide in the last hour of trading on Thursday — was falling off a cliff.

The first few minutes of trading on Friday morning continued Thursday’s dive, but Wall Street later came back from the edge, and by the time New York’s traders left for the bars or the suburbs, a degree of calm had returned. A day of volatility had shattered nerves but left shares a “modest” 1.5% down.

Nobody, however, believes the crisis is over. This weekend finance ministers and central bankers are trying frantically to prop up the system before the markets open. The week will not be a normal one, with public holidays in America and Japan tomorrow meaning trading on Wall Street and in Tokyo will be thin. That, however, will not provide an excuse for delay.

That was why, late on Friday night, G7 finance ministers and central bankers issued a statement promising to take “all necessary steps” to stem the crisis. Those steps include a pledge to stop key banks collapsing, a big boost to money market liquidity, putting taxpayers’ money directly into the banks as capital, protecting the deposits of savers and forcing banks to come clean on the scale of their losses.

The G7 knows that this crisis has reached a level at which mere statements are not enough. That is why Henry Paulson, the US Treasury secretary, promised to take a leaf out of Gordon Brown’s book and inject capital directly into US banks, a decision that is likely to be matched by Germany. And it is why worried eurozone finance ministers will get together in Paris this afternoon to make sure they all have their armoury in place by the time European markets open tomorrow morning.

Economists are bad at predicting stock market crashes, and those crashes are bad predictors of what will happen to the economy. Crashes have different causes and very different effects.

Black Monday, October 19, 1987, still ranks as the worst day on the market yet, when Wall Street slumped by more than 20%. It arose from international economic tensions, particularly in the foreign exchange markets. When those tensions spooked investors and led to a sudden collapse in share prices, many economists drew comparisons with 1929 and predicted a repeat of the Great Depression.

In fact, the result of the 1987 crash was more like the great inflation. Central banks, and in Britain’s case the chancellor, Nigel Lawson, cut interest rates in response to the plunging stock market. The result was the boom of the late 1980s, which turned to bust only in the early 1990s — and by historical standards it was a mild bust — when interest rates had to be hiked to combat the inflationary boom.

The stock market crash over the past week — the biggest weekly fall for America’s closely watched S&P 500 index and a drop of 21% for the FTSE 100 — may be no more a predictor of depression than 1987 was. But the circumstances are very different.

For a start, according to the Stanford University economist Nick Bloom, the recent volatility of the stock market is on a par with the 1929 crash and subsequent episodes in that period when the Depression took hold. Bloom, who spends some of his time at the London School of Economics, is one of a number of economists who think it is not the level of the stock market that counts but the extent to which it fluctuates.

Recent days have seen some of the wildest fluctuations ever, which leads him to think a bad recession is on the way. Britain, he says, could experience a 3% contraction in the economy next year. That may not sound much, but if it happens, it will count as the worst year since the 1930s.

The reason it is different this time, certainly from 1987, is that the stock market crash last week was a symptom of the wider credit crunch of the past 14 months. The most obvious effect of that crunch on the British economy has been a mortgage famine and falling house prices.

The fear gripping stock markets is that nothing governments or central banks do will prevent the banking crisis from getting worse and the credit crunch from sending the world into a deep recession, affecting all countries and all businesses. That, together with a mad scramble by under-pressure investors to liquidate all their assets, including commodity investments, produced the crash.

Where do we go from here? Simon Johnson, former chief economist at the International Monetary Fund, thinks the G7 countries did not go far enough. He wanted them to guarantee all bank deposits and set out a concrete timetable for action. Politicians, he thinks, are still held back by fears of “moral hazard” — helping out the banks who got us into this mess. “When you see the Titanic sinking, you don’t stop saving people because it is the shipbuilder’s fault,” he says. The urgent task now is to get the West’s banking system working again. As it is, much of it is barely functioning.

We will soon know whether governments can persuade the markets that they have a plan. This will probably be an international version of Britain’s £400 billion bank rescue, announced in the heat of battle last week.

If they can, it may yet be possible to avert disaster, to get the banking system working again, and for the world economy to get back to something like normal, though with painful slowdowns in Britain and elsewhere. Markets would stabilise and interest rates in the interbank markets, the key to whether the system is working, would come down. If not, economies will grind to an abrupt halt and a downward spiral will set in.

From The Sunday Times, October 12 2008