Big recessions really hurt. In the Anglo-Saxon world, we have forgotten what they look like. Between 1930 and 1933, annual output of the American economy fell by nearly 30%. This dry statistic disguises what big recessions feel like. A similar one in Britain today would destroy 8m jobs. More than one in four employees would be thrown out of work.

But there is more: in 1929 US shares fell modestly in value, losing a little more than 10% from their 1928 peak. By 1932 they had lost three-quarters of their 1928 value. And they did not get back to that level for almost a generation, until 1952.

This catastrophic collapse, by far the worst to hit the western world in the 200 years from the industrial revolution to the present day, was almost entirely unforeseen. There was no more than a slight hint that some mildly choppy water might be encountered.

This is not because economists at the time were wilfully stupid. Forecasting the economy is an incredibly difficult scientific problem. What happens in an economy is not something that can be controlled as if it were a machine.

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Background

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What happens depends on the decisions of millions of individuals and companies, all of which interact in complex ways. Each reader of this newspaper has to make regular decisions about how much to spend and how much to save. Each company, big or small, has to consider whether to expand and invest in new capacity or whether to cut back and get rid of people.

At any point in time – today, for instance – every individual will feel optimistic or pessimistic. Most of the time, across the country as a whole, these individual feelings will more or less cancel one another out, or at least not create too much of an imbalance either way. But occasionally sentiment spreads like a contagious disease. It is not so much the wisdom of crowds, but more the madness of crowds.

This is exactly how big recessions can start: not so much with a bang, to borrow TS Eliot’s phrase, but a whimper. Since the Northern Rock debacle last August, the newspapers have been full of rather disquieting news. But, to set against this, many things go on in a reassuringly normal way. Unemployment hasn’t really changed, stock markets haven’t actually collapsed, restaurants and wine bars seem pretty full, the transport system remains predictably bad and even the England cricket team continue to display their usual mix of skill and rubbish.

All these things, and myriad more, contribute to the degree of optimism or pessimism that any individual feels. We each have our own private opinion of how good or bad things are for us. But we hear from our immediate circle of family, friends and colleagues and we pick up stories about the economy from the media.

Each of us can be persuaded to become that bit less optimistic, even when our personal assessment is that things are fine. And in turn, when this happens, our sentiment becomes part of the broader picture, increasing the chances of other people turning pessimistic. Every so often, this bursts out of control. People and firms lose confidence about the future and cut back their spending, and a full-blown recession ensues.

The good news is that economies can withstand seemingly devastating shocks and emerge almost unscathed. In October 1987, completely out of the blue, stock markets collapsed. In a single day, the value of the world’s biggest companies fell by 20%. But nothing happened. Pessimism did not spread like the Black Death. Indeed in Britain the excesses of the boom of the late 1980s continued unchecked. House prices continued to soar; City traders continued to quaff champagne and collapse in stupefaction on their trains home to Essex. It was only two years later, for entirely unconnected reasons, that this particular party came to an end.

Even more telling is the experience of Japan over the past 20 years or so. By the late 1980s, Japan was the success story of the postwar era. Once derided for their cheap and nasty, unreliable products, Japanese companies had come to bestride the globe. Visiting American bankers were obliged to overcome their squeamishness and consume live lobster sashimi in deference to their hosts.

Yet in 1990 pessimism suddenly infested the economy, and during that year the Nikkei share index lost 40% of its value, bottoming out in 1993 at 80% lower than its peak of just under 40,000. Even now it is only about 12,000, less than one-third its level of 20 years ago.

The collapse in land values was even more complete. In the late 1980s rumours had abounded that certain golf courses in Tokyo were worth more than the entire real estate of California. Prices fell in large parts of the market by no less than 90%.

Imagine. You are living in a house apparently worth half a million. You wake up the next day and find its value slashed to £50,000. Surely that would precipitate mass pessimism and a recession just as bad as the American one of the 1930s.

Logic says it would. But it didn’t. In Britain we are each, on average, about 40% better off now than we were then, whereas in Japan the increase has been just less than 20%. Not brilliant, but far from being a disaster.

Quite how the Japanese avoided catastrophe is still a bit of a mystery. Certainly not just once but several times, most of the main Japanese banks became technically bankrupt. With great aplomb, the Japanese central bank simply changed the rules and said they no longer were.

But the contrast between America and Japan shows that mass psychology, the percolation of pessimism or optimism across the economy, is almost impossible to judge in advance. In America in 1930 shocks in financial markets led to a stupendous collapse of the economy. In Japan in 1990, in apparently similar circumstances, things just bumbled along.

For all this, there is undoubtedly a sense of unease out there. The technical phrase “sub-prime” has become common parlance, with even the tabloids feeling able to use it. There is a good reason for these worries. The slowdown in the American economy is not merely a figment of forecasters’ imaginations: it has actually been happening.

Debt. That is the word everyone is worrying about. Why? The chart on page two shows the growth of debt in America from 1920 until now. Of course, over such a long period of time population grows, the economy grows and prices change. We cannot simply compare the amount of debt out there in simple money terms. What the chart does is divide the total amount of outstanding debt owed by people and companies, including financial ones, by the size of the economy.

Shock, horror! Compared with the size of the economy, debt now is even greater than it was in 1929 – the blip in the left-hand side of the chart, just before the Great Depression. The value of debt owed by individuals and companies is now nearly three times the size of the economy. Surely this means we are headed for economic meltdown.

Up to a point, Lord Copper. The striking feature is the continuous rise in debt compared with the size of the economy over the entire postwar period. But the postwar period has been a time not of economic gloom but of unprecedented rises in living standards. A willingness to take on debt can often be a sign of confidence about the future. For individuals, it is a confidence that things will get better and the debt repaid. Even more important, companies with new plans, new ideas, need loans to translate them into reality.

Such plans often fail, but when they succeed the rewards can be spectacular. In the past 20 years or so we have seen American companies grow from nothing to become the biggest in the world, drastically altering the way we live our lives – Microsoft, Google and Facebook, to name but three. The people now working away in their garages in Silicon Valley with visions of overturning Microsoft – if they are actually going to do this at some point they will need to incur debt, and probably lots of it.

The problems, for both people and firms, usually start in one of two ways. Either you can no longer pay the interest on the debt. Or there is a sharp fall in the value of the asset that you have bought with the loan. When the value of the loan exceeds the value of the asset – negative equity – confidence tends to ebb away.

These things happen all the time. It is when they start happening to lots of individuals at the same time that we have real trouble.

“Sub-prime” means what it says on the label – “prime”, as in “prime beef”, meaning high quality. These are loans made to people who are not high quality in their ability to pay not only the interest but eventually the loan itself.

Sub-prime as such is not a bad thing. For a whole variety of reasons some people are less creditworthy than others. A spell of illness leading to a period out of work, a stressful and expensive divorce – such things can affect the best-intentioned individual.

It would be wrong to exclude such people from access to credit, but it comes at a price. Their loans are more risky, so the interest charged is higher. Every good, responsible bank or building society will make sub-prime loans. It is not inherently wicked but a normal part of business to weigh up the higher risk against the higher return.

The sub-prime crisis has arisen because the restraints on prudent behaviour broke down. Putting out risky loans came to dominate the strategies of some companies. Northern Rock’s notorious loans of five or more times the borrower’s income on more than 100% of the value of the property were almost tailor-made to end in tears.

Yet the board of Northern Rock was not made up of scallies from Liverpool or cockney wide boys. Far from it – most of its members had years of service at the highest levels of financial and consultancy companies. How did they think they could get away with what on the face of it appears to have been obviously irresponsible behaviour?

The answer goes back about 40 years, to a trio of American academics leading successful but blameless careers. These three men discovered ways of applying concepts from statistical physics to financial markets. Fischer Black, described by one of his close friends as “the strangest man I ever met”, left academia to make millions at Goldman Sachs before his death in 1995. Robert Merton and Myron Scholes received the Nobel prize in economics in 1997 for their findings.

Their highly esoteric discoveries had immense practical significance, enabling the creation of today’s industry of financial derivatives, worth over $500 trillion, according to the Bank for International Settlements.

The basic idea of derivatives – so called because their value is derived from, or related to, that of an underlying asset – is simple. Suppose an investor holds some Vodafone shares. He or she might worry that the price will fall. Someone else might think it will rise. A contract can be struck between them to trade the shares at a specified price at a specified future date.

The crucial feature of derivatives is that their price fluctuates much more than that of the underlying share to which they are linked. The rewards from getting it right can be much bigger, but so too can the losses. At present Vodafone trades at about 150p a share. If I feel optimistic about the company, I can buy the shares now. If at the end of April they are 300p, I will have doubled my money. But I could instead buy the right to buy them at, say, 250p at the end of April for virtually nothing, 1p say, since it is so unlikely that such a big increase will happen in such a short time.

If I am proved right and the price really is 300p, I have the right to buy shares at 250p and can then sell them immediately for 300p. My 1p has turned into 50p – far, far more than doubling my money. But if I am wrong and the price stays below 250p, I will lose everything I put in.

In short, derivatives both satisfy and create an appetite for risk. They enable much riskier bets – sorry, considered investment judgments – to be made than if you can just trade in the underlying shares themselves.

As it happens, Merton and Scholes got their comeuppance when they totally misjudged some risks. Their financial company, Long-Term Capital Management, collapsed in 1998 with a loss of nearly $5 billion, and was bailed out by the Federal Reserve, the US central bank. So today’s problems are not exactly without precedent.

But the trio had initiated a period of stupendous innovation in financial trading. The introduction of high-powered mathematics into the markets has created all sorts of previously undreamt-of possibilities. One of them goes by the name “securitisation”.

It is this obscure and seemingly anodyne concept that the board of Northern Rock relied on to dispose of the huge risks it was taking. And it is this that led the board to create Granite, the trust in the Channel Islands that has proved such a complication in the rescue of the company.

The Northern Rock board surely knew it was making loans to high-risk individuals. But the company could collect the fees for making each of the loans, and then bundle them up into a package. This package, containing a large number of risky individual mortgages, was sold to Granite. So the risk was no longer borne by Northern Rock but by Granite, an entirely separate outfit.

Granite found the money to buy the package by issuing securities. These securities were bought by sophisticated financial market operators, who could then in turn sell them to someone else, almost like shares on the stock market. The value at any point in time would depend upon how the individual loans were performing and on how different people assessed the risks involved in buying the package.

The mathematics of pricing these concepts soon gets hair-raising. But it is essentially a high-powered game of pass-the-parcel with a twist. Unlike in the children’s birthday party game, whoever is left holding the parcel when the music stops loses.

Northern Rock had been able to make the first pass in the game. The company had its fees and the lump sum paid by Granite for the package of loans and had offloaded the parcel. With a single bound it was free. Or so it appeared.

Northern Rock’s problem essentially was that other, bigger operators in America had already been passing the parcel for some time. Massive amounts of sub-prime loans had been wrapped up and sold on. But so much of this activity was hidden by Granite-like devices that financial institutions began to wonder what would happen when the music stopped. How many parcels were out there and who was holding them?

In addition, the maths of pricing many of the individual parcel-passing trades is so complicated that even the theoretical physicists doing it couldn’t always be relied on to get it right. It is certainly far beyond the capabilities of most board members in even the most august financial institutions.

This last point really gets to the nub of the current problem. A system has been created that is so complex, so convoluted, that even at the very highest levels in financial companies nobody really understands the level of risk that is being carried at any point in time.

The net result was that banks began to doubt one another’s credit-worthiness. So they simply stopped lending to each other. A real, no-holds-barred credit crunch.

For Northern Rock, that was a disaster. Not only had it been bundling up high-risk debt, but the company had also been borrowing large amounts of short-term money to expand the volume of its business – much larger amounts, relative to its size, than any other British bank or building society. When the time came to repay these loans, nobody would lend it the money to do so.

Much more worrying is the general loss of confidence among big financial institutions, where pessimism really has spread like the Black Death. Once this has happened, it is hard to turn round.

The Federal Reserve is doing its best under its chairman, Ben Bernanke. Luckily, one of Bernanke’s interests as an academic was the Great Depression of the 1930s. Its full mysteries have still to be unravelled even now, but Bernanke has more idea than most of what might help to prevent a recurrence.

One thing he has done is to cut interest rates sharply, but there is a limit to how far this can go. It is hard, for example, to cut them to the point where they are negative, where savers pay the bank to hold their money.

Much more important, the American authorities are willing simply to print money to keep the financial system going. For the past 25 years, governments and central banks have thought printing money a very bad idea. Printing money is supposed to lead to higher inflation. Keeping it low has been the main policy target of western governments since the 1980s.

This idea has not just gone out of the window in America; it has been positively thrown out. In all but the technicalities, the US Federal Reserve is giving American banks large amounts of freshly minted cash in exchange for their potentially dodgy loans.

In addition, Bernanke has reintroduced the concept of what might be called “moral suasion”. The governor of the Bank of England made the phrase “moral hazard” famous. It means making banks suffer for their misdeeds as an example to others, and it is the rationale behind the governor’s reluctance to bail them out.

Moral suasion is how the Bank of England used to operate before the complicated, rule-based, hugely expensive and bureaucratic tripartite control systems of the Financial Services Authority, the Bank and the Treasury were introduced.

The big American bank Bear Stearns appeared to be in serious difficulties. Using moral suasion, the chairman of the Federal Reserve persuaded JP Morgan, a rival bank, to take it over, with all its potential liabilities, over the course of a weekend. JP Morgan was under no legal or regulatory obligation to do so. But, somehow, it did.

This is exactly how the Bank of England solved the previous banking crisis in the 1970s. The shareholders of Bear Stearns have lost out, but a huge financial collapse has been avoided, at least for the time being.

There can never be a guarantee that policies will work. Pessimism could still spread, could still invade the economy as a whole in its sinister, insinuating way. But the Americans are doing their level best to prevent that.

We might reasonably ask: is all of this fair? Why should the ordinary person bail out the ostentatious and expensive lifestyles of the denizens of financial markets? The short answer is, quite simply, that it is not fair. But the alternative, simply to allow a potentially massive financial crisis to unfold, would not exactly be desirable. The expensive Mayfair and Central Park apartments, the country seats in the Cotswolds, the mansions in the Hamptons, these would still belong to the bankers even if they were unemployed. The problem is that millions of the rest of us might be out of work as well.

The abiding lesson from the 1930s is that, in a financial crisis, banks are more important than individuals. No matter how much money individual people may lose, the monetary authorities have ultimately to defend banks and not people.

Northern Rock shareholders have lost most of their money, and many Northern Rock staff face redundancy. But the bank itself has been kept going.

When put in these brutal terms it seems – indeed it is – grossly unfair. But letting big banks go under would run the risk of creating another great recession, with at least 30m people unemployed in America.

The real issue is how we got here, how risk has come to be rewarded within the financial system. Some of the trades being made have been simply lunatic, with no conceivable rationale other than to ramp up the risk to create the chance of making a killing now.

The whole panoply of expectations of financial players, of traders, of directors, of shareholders, has got out of hand. It is not just that the focus on returns is very short term; even more important is the size of returns that is now expected.

A perfectly viable, healthy and wealthy system could exist with lower overall levels of return. But current expectations demand leverage, the taking of risky positions and the creation of complex financial instruments, to satisfy the demand for that risk.

More and more rule-based directives and regulation is not the answer. Regulation of this sort can be actively counterproductive, for by setting explicit rules it encourages creative individuals to find (legitimate) ways round them. And going down this route leads us little by little, almost imperceptibly, to a stage where we really no longer have a dynamic, market-oriented economy but one that will end up like the basket case that the centrally planned Soviet Union eventually became.

Punitive intervention and regulation is the nuclear option. Governments have the power to use it and maybe, unless the financial sector itself starts to clean up its act, one of them will. In a democratic society there can be only so many James Caynes before governments feel compelled to strike. Cayne, the chairman and chief executive of Bear Stearns, was paid $40m between 2004 and 2006 and made millions more by selling his shares. But he has just presided over the destruction of virtually the whole value of the shares in the bank.

Finally, what are the prospects for the ordinary person in all this? Not good, I’m afraid. If there is another great recession, tens of millions in the West will suffer real hardship. If we manage to avoid it, even more will feel it in their pockets in a much less dramatic but still noticeable way.

The cost of all these exotic financial schemes gone sour has to be paid for, whether by reduced pensions as the value of bank shares held by the pension funds falls, by higher taxes or by higher mortgage fees and rates as banks build up and restore their balance sheets. It is simply too late to do anything else this time round.

The real challenge is to make sure we do better when the next financial crisis happens. When will that be? Neither I nor anyone else knows the answer. What we do know is that at some unknown point, at some unpredictable time, there certainly will be one.

Paul Ormerod is the author of Why Most Things Fail and a director of Volterra Consulting

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