Bill Emmott - International Author & Adviser


The Western Credit Crunch, one year on
Ushio - September 2008

The date that is conventionally chosen to mark the beginning of the so-called “credit crunch” in America and Europe is August 9th 2007. So one year has now passed of what officials from the normally cautious International Monetary Fund in Washington, DC, have described as the worst financial crisis since the Great Depression of the 1930s. It is therefore a good moment to ask: what have we learned in the past year?

            The first thing we have learned, or been reminded of, is that finance is a rather technical and esoteric affair, a business that can seem disconnected from real life. August 9th was simply the day on which a French bank, BNP-Paribas, announced that it was unable to put a value on its holdings of securities linked to low-quality American mortgages, which we now know as “sub-prime” mortgages.

That simple announcement sparked off a panic in financial markets, during which banks and other firms dramatically cut their lending to each other, as trust in financial firms’ creditworthiness evaporated. Other specialist financiers that had depended on high levels of borrowing in those same money markets, such as private equity investors, also found that their business conditions had suddenly deteriorated, for they could no longer borrow so easily and cheaply. Dramatic judgments, such as that by the IMF, started to be heard about how bad the crisis could become. But normal economic life carried on, almost as if nothing had happened. Unemployment did not suddenly increase. Rates of economic growth did not suddenly collapse.

The second lesson, however, has been that this disconnect between the dramas in financial markets and the placid nature of ordinary life was more apparent than real. The true origin of the credit crunch lay not in the technical announcement by a French bank but rather in the fall in house prices that was already under way in the United States, which was leading more and more people who had borrowed to buy their houses to default on their mortgages. This was especially true of poorer people, in the “sub-prime” market, to whom lending had been particularly reckless.

Since then, we have seen how when each bank changes its lending policy in what seems like the most rational and sensible response to problems, the overall result can be that the problems become much worse. Banks stopped lending to each other, which raised funding costs for everyone. Banks in countries where house prices have been falling—which includes not just the United States but also Britain, Ireland and Spain, among others—have cut their lending to house buyers and have tightened the terms they demand from borrowers. This, in turn, has meant that there is less money to buy houses, which has helped the fall in prices to accelerate.

This process by which a contraction of credit leads to new falls in asset prices, a worsening of economic conditions and then to more defaults on debts, both by households and companies, is just what happened in Japan in the 1990s. At first, when Japan’s financial bubble burst, the consequences did not look too bad. But then they gradually accumulated, getting bigger and bigger. The danger for America, Britain and the other countries where asset-price falls are occurring most rapidly is that a similar accumulation of bad debts and bankruptcies could take place there.

This is why in the first few months after the crisis became visible on August 9th, the big fear was of deflation—as in Japan in the 1990s. Yet in the past year we have learned a third lesson: that America and Western Europe are no longer the centre of the economic world. Instead of deflation, we have seen a surge in inflation during the past year. The reason is that, in the world as a whole, there is no credit crunch. Instead, there remains a glut of credit, of money swirling around looking for a home. That surplus money is especially to be found in China, India, other emerging markets, and the resource-producers such as Russia, Saudi Arabia and the Gulf countries.

Hence, what we have seen is a doubling of oil prices even while the world’s biggest economies, in America and the European Union, have been slowing, and a rapid rise in the prices of other commodities. That has greatly complicated the task of the Federal Reserve and the European Central Bank in dealing with the Western credit crunch, for they should cut interest rates to avoid deflation but raise them to prevent inflation. It has also, however, meant that the American economy has been supported by rapid growth in its exports, for with the dollar falling demand for American exports has been buoyant. That is why America is still not officially in recession, a year after the credit crunch began and despite a fall in house prices of more than 20%.

The pressure of inflation will be eased as and when emerging markets such as China and India succeed in controlling their own money-supplies and in slowing down their own growth. Strangely, this effort to reduce the growth of bank lending in emerging markets could then assist the developed countries to prevent their own lending from contracting too much, as falling oil and food prices would allow the Fed and the ECB to cut their interest rates further and to supply more money themselves.

Yet that brings us to the final lesson. It is that in this complex, globally connected economy we cannot be sure of the consequences of policy changes and of market movements. Slower growth in China and India, combined probably with currency revaluation in China, the Gulf countries and other trade-surplus nations, could bring the world economy back to a sustainable balance and thus to health. Or that slower growth could itself bring problems, by causing a new fall in asset prices, a new round of debt defaults and credit contraction, and finally lead the world into the deflationary spiral that was initially feared. It is too soon to judge how this economic episode will turn out.


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