Bill Emmott - International Author & Adviser


A healthy financial shake-out
Corriere della Sera - August 17th 2007

When financial markets rise by three or four percent each day, no one pays much attention. But when they fall each day by that amount, it becomes front-page news. Reporters soon resort to absurd exaggerations. The Financial Times of August 16th, for example, started its report by talking of “panic selling” and “extreme bearishness”; but all it was reporting was a 1.4% fall in America’s S&P 500 share index, taking it 0.8% lower than its level on January 1st. What words will they use for the 4% drop in their own FT-SE 100 index today? The end of the world? Or if shares later fall by 10%? Apocalypse now?

            In other words, far too much fuss is being made about this month’s falls in share prices and the associated problems in the market for debt. The president of France, no less, has interrupted his holiday in America to write a long letter to the chancellor of Germany about what is going on, and to make rather a technical point: that there should be an investigation into the role of credit-rating agencies.

            It is not that Nicolas Sarkozy is wrong. It is that such matters are not the sort of things that French presidents and German chancellors should be writing to each other about. Yes, the credit-rating agencies, such as Moody’s and Standard & Poor’s, do encourage investors to be complacent, which is what has happened in the case of America’s sub-prime mortgage market and all the clever financial instruments attached to it. The agencies can only base their evaluation on historical data, and when the securities are new the historical data tells us nothing.

            Simply the name of this mortgage market should, however, have been a clue: sub-prime. It means that the people borrowing money in this market to buy houses are bad risks. They are likely to default on their loans when times turn bad. During the past five years, America has had a boom in house prices, just like those in many European countries such as Britain, France and Spain, fuelled by low interest rates. Eventually that boom was always likely to come to an end. When it did, the weakest borrowers would default. People who bought securities linked to their debts were likely to lose money. That is what is now happening.

            No investigation into the credit-rating agencies will change that basic fact. So how worried should we be about it? There are three things that we can say.

            The first is that this shake-out in the financial markets is not over. As lenders lose money, so they and all other lenders will become more cautious about lending more, which in turn will affect companies trying to borrow for all sorts of purposes all over the world. It will take several months before this process is fully played out.

            The second is that this is actually a healthy process, in economic terms. When times are good, interest rates are low and credit is easily available, people and firms always end up doing crazy things. The only way in which that craziness can be limited is if there are market shake-outs from time to time.

            The third is that the world in general, and Europe too, is well placed to absorb this shake-out without the damage being too great. Economic growth worldwide has had its best four years for more than 40 years. That growth has had many participants, from America to China to Japan to Latin America and, especially in the past year, to Europe, all helping each other expand. Companies have been making record profits and many of them have repaid debts and built up reserves of cash. Perhaps growth will, as a result of this shake-out, be slower next year than this year. But the slowdown need not be too painful. It may even help to reduce oil prices and inflation.

            A fourth thing that can be said, however, is that when markets go through shake-outs, it is always possible to turn a drama into a crisis or even a catastrophe. Usually, that happens when politicians start to interfere.


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