How a local squall might become a global tempest


The phrase "perfect storm" has been trotted out once too often to characterise the past year's financial crisis. Yet the real perfect storm may still lie ahead.

Fans of the George Clooney film will recall that the perfect storm was caused by the convergence of a hurricane off the Atlantic seaboard, an area of low pressure south of Nova Scotia and a cold front swooping down from Canada. Result: howling winds, vast waves and the loss of at least one boatload of Gloucester fishermen.

One year after the onset of the financial crisis we are still calling the "credit crunch", could we be witnessing a similar catastrophic convergence, as the slow-moving hurricane of a US banking crisis hits first a commodity price rise and then a global slowdown?

Until now this crisis has been primarily a US affair, albeit with collateral damage (literally) on the balance sheets of many European banks. The crisis had its origins in a US real estate bubble fuelled by easy money and lax lending standards. Ordinary Americans gave up saving, pinning their hopes for the financial future on a leveraged play on the real estate market. In barely a decade, household sector indebtedness surged from 90 per cent to 133 per cent of disposable personal income. At its peak in August 2004, annual house price inflation exceeded 20 per cent.

With the inevitable bursting of that bubble, the process has gone into reverse. House prices are falling at an annual rate of 15 per cent. The catalyst for the bust were defaults by subprime borrowers but, as prices continue to fall, less marginal homeowners are coming under pressure. Credit Suisse recently forecast that by the time the crisis is over as many as 6.5m loans will have fallen into foreclosure - more than one in 10 of all US mortgages.

A property crash like this has not been seen since the Great Depression. The difference is that the monetary and fiscal authorities have done everything in their power to prevent a repeat of what Milton Friedman and Anna Schwartz dubbed "the great contraction" between 1929 and 1933. What happened then was that falling asset prices caused thousands of banks to fail, while the Federal Reserve did almost nothing to mitigate (and a good deal to accentuate) the consequent monetary implosion. Under Ben Bernanke's historically informed leadership, the Fed has done the exact opposite, slashing interest rates and, more importantly, targeting liquidity at banks through the discount window and new term auction facilities.

This has so far averted a full-scale banking crisis but it is important not to overstate the achievement. Most kinds of mortgage-backed securities have not significantly recovered from the initial crisis, while the market for collateralised debt obligations is all but dead. After writedowns in excess of $400bn (?260bn, o205bn) and capital injections of about $300bn, many banks still look fragile. Shares in at least 40 US banks are down 70 per cent or more. We know the US Treasury will intervene to avert the collapse of institutions it deems too big (or important) to fail: witness the brokered sale of Bear Stearns and the hasty bail-out of Fannie Mae and Freddie Mac. But many second-rank banks seem certain to follow Indymac into oblivion.

Call it a partially contained banking crisis, then. The impact on the rest of the economy is still bound to be serious. Before the crunch, credit extension in the US was growing at 4 per cent a year; now the figure is minus 7 per cent. The evidence is mounting that the US economy is on the brink of recession. Business bankruptcies are up, payrolls are down and corporate earnings have slumped. And, of course, as things get tough on Main Street there will be a second wave of financial problems, beginning with corporate defaults and commercial real estate blow-ups.

The question is whether or not this American hurricane is about to run into two other macroeconomic weather systems. Up until now the global impact of the crisis has been limited. Indeed, strong global growth has been the main reason the US recession did not start sooner. With the dollar weakened as an indirect consequence of the Fed's open-handed lending policy, US exports have surged. According to Morgan Stanley, net exports accounted for all but 30 basis points of the 1.8 per cent growth in US output over the past year.

The downside of this, however, was a rise in commodity prices as strong Asian demand coincided with a depreciating dollar. For a time, this coincidence of a US slowdown and soaring oil prices revived unhappy memories of 1970s stagflation. But now a new and colder front is crossing the macroeconomic weather map: the prospect of a global slowdown.

Admittedly the forecasts do not sound too alarming. A reduction in global growth from 4.1 per cent this year to 3.6 per cent next year could positively help damp inflationary pressures. Optimists such as Jim O'Neill at Goldman Sachs celebrate the "decoupling" of China from the US, pointing out that nearly all China's growth is accounted for by domestic demand, not exports.

Yet there are four reasons to be less cheerful. First, Europe has clearly not decoupled from America. Indeed, partly because of the strength of the euro, the eurozone is now growing more slowly than the US. And remember: the European Union's economy is still more than five times larger than China's. It also matters a great deal more to US exporters.

Second, the commodity price rise has generated inflationary pressures in many emerging markets that will not recede overnight. According to Joachim Fels of Morgan Stanley, 50 of the 190 countries in the world currently have double-digit inflation. The World Bank has identified 33 countries where high food prices have already generated civil unrest.

Third, decoupling is not a cause for celebration if, on closer inspection, it is a synonym for deglobalisation. The growth of the world economy since 1980 has owed much to lower trade barriers. Unfortunately, the recent breakdown of the Doha round of global trade talks sent a worrying signal that commitment to free trade is weakening. It was troubling, too, how many governments responded to the jump in rice prices by imposing export restrictions.

One year on, what began as a US crisis is fast becoming a world crisis. Small wonder only a handful of global equity markets are in positive territory relative to August 2007, while more than half have declined by between 10 and 40 per cent. The US slowdown will also affect many emerging markets less reliant on exports than China. At the same time, the global slowdown is about to kick away the last prop keeping the US recession at bay. No, this is not the Great Depression 2.0; the Fed and the Treasury are seeing to that. But, as in the 1930s, the critical phase is not the US phase. It is when the crisis goes global that the term "credit crunch" will no longer suffice.

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