By Larry Elliott (THE GUARDIAN, 17/08/07):
The global financial markets have turned ugly. August has seen a spasm of selling on stock markets as dealers have come to terms with the fact that the days of unlimited, cheap credit are over. Yesterday, there was a whiff of panic in the air. In London, the FTSE index lost 250 points and closed below 6,000 for the first time since last autumn. This followed a big stocks selloff in Asia, which in turn was prompted by a warning from investment bank Merrill Lynch that the US mortgage lender Countrywide could go bust as a result of the crisis in the American housing market.
Merrill’s comments underline the seriousness of the situation, because Countrywide is the US’s biggest home loan provider. So when you hear over the coming weeks that this is just a market wobble and will soon blow over, take it with a pinch of salt. Those who say such things are either lying or in denial. Two months ago, these same experts were saying that the problem in the US sub-prime market was contained. That was before stock markets fell by more than 10% and reports of institutions in trouble surfaced in Australia, France, the Netherlands, Britain and the US. The relevant C-word here is not containment but contagion.
The good news, such as it is, is that all this is happening at a time when the emergence of India and China means the global economy has been experiencing its longest period of strong growth since the early 70s. Corporate profits are healthy. US manufacturers are taking advantage of a cheap dollar to export more. Britain’s economy has been humming along at about 3%, and figures yesterday showed bargain-hunters out in force on the high street last month. So why worry? This, it has been argued, is just a repeat of 1998, when the Russian debt default resulted in the collapse of the Long Term Capital Management hedge fund.
There are, however, crucial differences. In the 1990s, there were financial crises, but the flashpoints were in developing countries. This time the problem is in the US itself. Moreover, it is a problem that has been brewing for two decades. In the 1990s, the Federal Reserve, the US central bank, provided cheap money to get the economy going and helped create the biggest stock market boom in the country’s history. When the bubble burst, it solved that problem by creating the US’s biggest housing bubble to date. The bubble burst about a year ago, but the pain will last for a long time.
Finally, as Nouriel Roubini, economics professor at New York University puts it, there is a difference between crises of liquidity and crises of insolvency. Liquidity crises are those in which firms and individuals have a cashflow problem; interest rate cuts help them through the tough times. Insolvency crises are much more serious; slashing rates makes no difference when people are going bust. The LTCM collapse was a liquidity crisis, Roubini says, and what’s happening now is an insolvency crisis.
Hundreds of thousands of households are insolvent, mortgage lenders are going belly-up, construction firms are going out of business, hedge funds that traded complex securities backed by sub-prime loans are going bankrupt. Conclusion? This has the potential to be very serious indeed.
For Britain, the implications of a crash would be particularly dire. Over the last year, the financial and business services sector has been responsible for almost half of the growth in the economy. There have been two sources for this strength – the City and the housing market. Five interest rates rises over the period have started to take the edge off property prices and there is now a real possibility that London, which has marketed itself as a giant offshore hedge fund for those that want to dabble in risky derivatives trading, will find business drying up. That will have significant knock-on effects on the City’s penumbra – the corporate lawyers, PR firms, restaurants, car dealers – that have benefited from the financial sector’s rapid growth.
It is deeply troubling that Britain has all its eggs in one basket. Government ministers talk airily about the creation of a knowledge economy, but what that means in practice is that the country’s best mathematicians are employed by City firms to construct elaborate and, as it turns out, useless models to price risky financial instruments. These models have never been stress-tested because the people who created them assured us that the sort of problems we are now experiencing would happen only once in 10,000 years.
It is an exaggeration, but perhaps not much of one, to say Britain is dependent on speculation. The Germans are feeling the heat from the market turmoil but they use their bright people to create products people want to buy. That’s a knowledge economy. Britain uses its brains to develop products that have no intrinsic value and have helped take the global financial system to the edge of the precipice. That’s a stupid economy.
So what happens now? It’s tempting to say those who have sowed the wind through greed and arrogance should reap the whirlwind. There is some irony in listening to the calls for welfare for hedge funds from the people who normally argue governments should get out of the way and allow market forces to decide which companies survive or fall. The very people in the City who have been holding a gun to the heads of ministers by threatening to up sticks and move offshore unless they can be guaranteed a light-touch regulatory regime now expect the taxpayer to help them out. But a financial collapse would end up hurting millions of innocent savers and investors. Ministers could no more allow one of the big banks to collapse than they could allow a hospital that ran into financial trouble to close its doors.
It would, however, be unimaginable for ministers to write a blank cheque to an NHS trust without demanding something in return, particularly if that trust had allowed its hospital to dabble in controversial, experimental and highly risky new treatments. There would be wholly justified demands for regulatory standards to be tightened and for activities deemed unacceptable to be reined in, and this would be the case even if the health service were not publicly funded.
Similar conditions should be placed – now and without any hesitation – on big finance. The current parlous situation is the result of a toxic combination of recklessness and cupidity. We need to ensure it never happens again.