The spectacle of customers queueing outside a small California bank on Monday
to withdraw their deposits was unsettling enough for an American public
already traumatised by a year-long financial crisis.
But there were two things about the collapse of IndyMac, a lender based in
Pasadena, just outside Los Angeles, that were especially troubling.
The first was that, as the federal authorities moved in to rescue the failed
lender, they revealed that they had for some time been compiling a lengthy
list of banks around the country that, because of their mounting
difficulties, had been placed on a kind of death watch.
The scarier thing was that IndyMac was not even on the list.
The bank’s failure – which mirrored the crisis in Britain over Northern Rock –
was only one of a series of dizzying events in the past week that suggest
that the turmoil that has battered the US economy and threatened the
stability of the global financial system has entered an ominous new phase.
In Washington and New York last weekend the financial authorities clocked up
yet more overtime as they cobbled together a plan to rescue two of the
nation’s largest financial institutions, Fannie Mae and Freddie Mac, whose
core business is the very lifeblood of the vast US housing market.
On Monday rumours of imminent failure swirled around a number of small and
medium-sized banks across the nation. One of the country’s largest
investment banks, Lehman Brothers, was once again battered by speculation
that it could not meet its liabilities. The whole US banking sector posted
their largest one-day decline in share prices since 1989.
Yesterday investors around the world joined in the panic, pummelling the US
dollar, which dropped to yet another record low against the euro. The
dollar’s latest losses also pushed the pound back above the $2 mark.
The mood among policymakers in Washington is one of growing dismay; some might
call it alarm. Despite their best efforts to keep the world’s largest
economy afloat, despite a succession of unprecedented measures to restore
calm to financial markets, the situation continues to deteriorate.
Yesterday, even as Ben Bernanke, the chairman of the Federal Reserve, the US
central bank, Henry Paulson, the Treasury Secretary, and even President Bush
sought once again to reassure markets, there was a deepening sense that the
worst of the financial turmoil may be yet to come.
One senior central banker likened the role of policymakers to that of the hero
in a science-fiction movie. Faced with a mortal threat, he tries everything
to avert disaster but nothing seems to work. He frantically pushes buttons
and pulls levers, but it is no good. Nemesis, in the form of an alien, a
giant beast or a headlong, bone-crunching rendezvous with eternity, is
inevitable.
A year ago the term “sub-prime mortgage” migrated from the lexicon of obscure
financial terminology to the daily conversations of worried consumers and
investors around the world. Banks that had invested too heavily in this
always high-risk mortgage business suddenly found themselves with huge
losses as US house prices fell and interest rates rose.
In the past 12 months the Federal Reserve and the Treasury – along with other
authorities in other countries – have moved with astonishing speed and
creativity to try to save the system. They have extended special lines of
credit to banks in trouble and dramatically increased the number of
financial institutions permitted access to central bank funds. The Fed has
cut interest rates seven times, by a cumulative 3.25 percentage points, to a
level well below the inflation rate. It has orchestrated the rescue of Bear
Stearns, one of the nation’s most famous investment banks, and now it has
backstopped the losses of the nation’s largest mortgage companies.
And still, like the villain in the movie, the threat seems to be getting
larger and closer.
As Mr Bernanke, with characteristic understatement, told the Senate yesterday:
“Although these policy actions have had positive effects, the economy
continues to face numerous difficulties, including ongoing strains in
financial markets, declining house prices, a softening labour market and
rising prices of oil, food and some other commodities.”
The immediate reasons for the continuing problems are obvious. The world is in
a pincer-like grip from two concurrent shocks. The first is the credit
crisis. In the US, house prices have fallen by at least 15 per cent from
their peak of late 2006. At the same time the prices of shares on the stock
market have fallen by more than 20 per cent.
In short, US household wealth has declined by almost a fifth. Since so much
economic activity was funded by credit that was secured on that wealth, it
is not hard to understand why that credit has dried up. Worse, of course, as
the prices of assets continue to fall, it is almost impossible for financial
institutions to gauge just how large their losses will eventually be and so
they cut their lending even further for fear that there may be more losses
ahead.
At the same time, and significantly complicating the ability of the
authorities to resolve the credit crisis, inflation is accelerating rapidly,
for the first time in 20 years. Rising oil and food prices are crimping
consumers’ spending power and limiting the ability of central banks to cut
interest rates, for fear of igniting an inflationary spiral.
These challenges are rooted in a much more fundamental change in the world
economy in the past decade – globalisation.
Back in the 1990s and early 2000s, the world economy was benefiting from
conditions that were precisely the reverse of the current climate: easy
credit and low inflation. As China and other emerging markets grew rapidly
on the back of surging exports to the developed world, the money they earned
had to be reinvested somewhere. They poured funds into assets in the US and
Europe, driving down returns on those assets and pushing interest rates
lower.
Flush with cash, financial institutions everywhere threw money at investment
opportunities: from vast construction projects to sub-prime mortgages. At
the same time China’s emergence helped to push down inflation by vastly
increasing the supply of cheap labourand goods.
Then this virtuous circle turned vicious. Banks overreached by investing in
projects that were way too risky.
As China and India grew more prosperous they began to add to inflationary
pressures, rather than subtract from them, by demanding more oil and food
and pushing up the global prices of commodities. As the US – which had been
growing beyond its means for years – began to adjust, the dollar plummeted
on foreign exchanges. That put further upward pressure on prices since a
lower dollar means that imports become more expensive.
The one piece of good news is that the worst fears of many in financial
markets have not been realised – so far. The US economy has continued to
produce meagre growth for the past year; the British economy, though
weakening, is still expanding.
But there are signs that a new deterioration may be under way. As yesterday’s
inflation figures on both sides of the Atlantic showed, price pressures
continue to rise.
The eurozone, which has weathered the first phase of the crisis without
serious economic damage, is starting to suffer.
The biggest immediate threat, though, is the health of the financial system.
There is a deepening mood of uncertainty in the US. The simple inescapable
fact is that the value of US houses and stocks is 20 per cent or so below
where it was two years ago. That will require a prolonged period of
retrenchment by American consumers and businesses as they adapt to their
reduced wealth.
More worryingly it will almost certainly require the US Government to put up
perhaps hundreds of billions of dollars in hard cash as a floor under the
tumbling financial system. Those queues outside the Indybank branches in
California were not really necessary – the Government guarantees everybody’s
deposits up to $100,000. But more collapses like that will put great
pressure on America’s public finances and that could push the dollar even
lower, adding a new leg to the downward spiral already under way.
It will end, of course, in time. House prices will fall to a level at which
they look cheap again. Banks will finally clear the backlog of dead and
dying assets from their books.
In the process, demand will weaken sufficiently to bring down the price of
goods such as oil and food and the inflation threat will pass. Central
bankers in Washington and around the world seem to think that this process
will take at least another year or two. And in the meantime they – and we –
can only hope that the route from here to there is a straight one.
Five worst slumps
1 1929-33: Great Depression 11,000 of America’s 25,000 banks closed and
number of unemployed rocketed Result: global depression
2 1989-93: The savings and loans crisis More than 700 lenders failed.
The crisis cost more than $160bn Result: recession
3 Now: Collapse of US sub-prime mortgage market has spread financial
panic worldwide Result: unclear
4 1980s: Latin American debt crisis The flow of international capital
to region dried up, leaving massive debts Result: global economy weakened
5 1973-74: Secondary banking crisis Slowdown led to three-day week
Result: recession
Source: Times Archive
