Economics: We will survive

‘This is the end of western civilisation as we know it’ – that was budget
director Lewis Douglas’s remark when President Roosevelt took the US off the
gold standard in 1933. It clearly was not, though, and neither was the UK
secondary banking crisis in 1974-75, the Latin American default and the US
savings and loan turmoil in the 1980s, the failure of hedge fund Long-Term
Capital Management, the Asian contagion and Russian default in the 1990s, nor
the end of the dotcom boom. At those supposedly cataclysmic times, some felt
capitalism itself was undermined; those events, by and large, are now footnotes
in the economic history books.

This is not to say there were no risks or costs. There obviously were, to
governments, taxpayers, shareholders and employees, but the wider economic
system proved strong enough to survive. The same apocalyptic visions are now
being painted following the so-called “credit crunch” on Wall Street, although
now Congress has finally passed the Bush/Paulson bailout plan, in its amended
form, a sense of optimism, or relief, is slowly emerging. As Churchill once
said, the Americans can be relied on to reach the right conclusion – once they
have exhausted all the alternatives.

Viewed from London, it is unfair to claim that the bailout, which could cost
the average American taxpayer around $5,000, is even absolutely necessary – and
nobody can know at this stage whether this “rescue” plan would even work.
Something, however, had to be done. It might be the least worst solution, but
there is no Plan B. The immediate response of equity markets to the measure has
to be taken as a vote of confidence for Congress’s actions, even if the
electorate appears ambivalent.

Moving beyond finding someone to blame for the massive economic cloud
currently hovering over most of the western world and its most prominent
affiliates elsewhere, attention now must focus on the next steps and the
implications for the UK economy. The first and most obvious point to make is
that, despite the dramatic headlines, the credit crunch is essentially a banking
crisis, a crisis about certain individual institutions and a crisis about banks’
relationships with each other. Until now, the collateral damage was limited. The
British economy was heading south anyway and the financial turmoil simply nudged
it in the direction it was already moving. The credit crunch did not cause the
downturn.

Although banks have had a largely hostile press, their role as intermediaries
between savers and borrowers remains vital. Financial institutions, in effect,
provide the plumbing for the economy, but that plumbing is now blocked. In
particular, it is the crucial inter-bank market that is blocked: the retail
deposits most banks take in from savers are now insufficient to support their
lending activities, so they need to borrow extra funds from other financial
institutions. As domestic bad debts mount and the holdings of toxic mortgage
packages plummet in value, confidence between banks has deteriorated and the
price of any lending between them risen.

This is the heart of the problem. Normally, there is barely a cigarette paper
between Bank Rate, the benchmark for banks’ retail activities set by the
Monetary Policy Committee, and the market-determined Libor, the key wholesale
market rate. But over the past 18 months or so a significant gap has emerged,
100 basis points or more. Closing the gap is not about Gordon Brown or Mervyn
King, but about confidence and liquidity in the banking system. Hopes are high
that the US congressional action is a first major step to a recovery in
confidence everywhere.

Recovery in the UK also means containing the toxic spill from banking into
other areas. While activity on all fronts is very obviously slowing, the
consensus remains that any recession will be mild and relatively short-lived and
certainly not on the scale of the early 1990s. The decline in financial services
is likely to be offset by more spending on public services (which accounts for
about the same share of GDP), financed by extra borrowing. Manufacturers will
need to look to export markets, while a cut in interest rates to 4% during the
course of 2009 will ease the debt pressures on households.

At any rate, recovery will come slowly. Debt will take time to unwind in a
low-inflation environment and the three industries that contributed so much to
growth in the last decade – financial services, retailing and property and
construction – are now under serious pressure. The UK will need to look
elsewhere for the new drivers of GDP. And the post-credit crunch world will
clearly be different from the last few years. Risk, rather than market share,
will be the priority for lenders and a more cautious attitude is likely to
prevail.

This is an essential, if painful revolution, needed to ensure any recovery is
sustainable rather than just a quick fix that will only lead back to the same
old problems. Difficult as this rebalancing sounds, and as uncomfortable as it
may be for some, at least now – after the American “rescue” package – we can
think in terms of recovery.