Originally posted on sciy.org by Ron Anastasia on Sun 31 Aug 2008 01:15 PM PDT
Scotland's award-winning independent newspaper
August 31, 2008
Have we really never had it so bad?
SO, IS it the worst economic crisis in 60 years? Worse than the 1970s with its hyperinflation and the three-day week? Worse than the recession of 1990-92 when hundreds of thousands of people lost their homes in the property crunch? Alistair Darling may have let his words run away with him - he has now insisted that he didn't intend to be quite so apocalyptic in his assessment of the credit crunch. However, he was only reflecting a view which is pretty widely held by people in the financial community.
George Soros, the billionaire who made his fortune betting against the pound during the Exchange Rate Mechanism crisis of 1992, has been saying for most of the last year that this is the worst economic dislocation since the Great Depression in the 1930s. Professor Nouriel Ruobini of New York University has also been talking about financial armageddon. Many others agree with him, though few express their fears openly for fear of being accused of alarmism and "talking ourselves into a recession".
But there are good reasons for alarm. The dynamics of this crisis are disturbingly similar to what happened to the world economy in the late 1920s, when irresponsible lending by banks - primarily, but not exclusively, in America - led to huge asset bubbles in real estate and equities which burst, creating bank failures and a restriction of credit which became the Great Depression.
In the Roaring Twenties, money was cheap. People borrowed at low rates of interest to buy houses and shares, and a feeding frenzy ensued as everyone thought they could get rich by doing nothing but riding the boom. When reality bit, it took two decades for the bad debts to work out of the system.
In the late 1990s, low interest rates created an equity bubble in the great dot.com frenzy which burst spectacularly in 2000 and led to the stock market losing nearly half its value over the next three years (aided by the aftermath of September 11, 2001). To avoid recession, central bankers in America and Britain cut real interest rates to below zero in the hope of boosting economic activity. They succeeded, but only at the cost of inflating the biggest property bubble in history. House prices in America doubled; in Britain they tripled.
The property bubble has now burst in spectacular fashion across the industrialised economies. It began with sub-prime in America, but quickly spread to other categories of mortgage lending. American house prices are down 20%; in Britain, values are down more than 11% on the last ten months.
The problem is not just house prices, however. The banks had lent hugely on the basis of inflated real estate values. Huge waves of leveraged debt swept through the economy. Banks started trading mortgage related-bonds on the securities markets as if they were cast-iron Treasury-backed bonds. People lost any concept of risk.
When property prices began to collapse in America in 2006, the foundations of this credit structure were pulled away and the inflated values of bonds collapsed.
Banks have lost a fortune and have had to increase lending rates to mend their balance sheets. They have become risk-averse, refusing to lend to first-time homebuyers unless they put up 20% deposits; unwilling to lend to firms unless they have absolutely rock-solid balance sheets.
Banks, such as Northern Rock, that depended on asset-backed securities were the first to go. With losses from sub-prime loans in the US expected to rise above $1 trillion, a wave of bank failures is under way in America. And with the huge US government sponsored mortgage lenders Fannie Mae and Freddie Mac in deep trouble over their $5.2 trillion mortgage book, there are fears for the security of the world financial system itself. Banks lend many times the actual reserves they hold, and at the moment many are effectively insolvent and dependent on state support.
Central banks, such as the Bank of England, have stepped in to buy much of the bad debt, but they can only go so far. When the central bankers use up their available funds and once the banks burn up their assets, there could be a complete meltdown in the global financial system. At the very best, we face a decade of credit restriction and an inevitable recession.
Alistair Darling is trying to prepare us for hard times ahead. I suspect he knew exactly what he was doing when he shot his mouth off.
Attachment:
