Today's views of the economy!

Today's views of the economy!

THE TIMES   17.7.08
The real reason why bankers feel so gloomy
We could be on the verge on the greatest slump of all time... if you 
ignore the encouraging economic figures
Anatole Kaletsky

According to the overwhelming majority of financial analysts in the 
City of London and Wall Street, the world is now in the worst 
economic crisis since the 1930s. Anyone who doubted this cataclysmic 
consensus - and I must admit that I played down the credit crunch, 
describing it initially as a "storm in a teacup" - must surely be 
eating humble pie after the events of last weekend, when the two 
largest financial institutions in the world - Fannie Mae and Freddie 
Mac - teetered on the brink of bankruptcy, despite the US Government 
effectively guaranteeing their debts. The debts of these two US 
mortgage insurers come to about $5 trillion, equivalent to the 
combined national incomes of Britain and France.

If the US Government can no longer be trusted to meet its financial 
obligations with dollars that it can print on its own printing 
presses at will, then there really is no place to hide. That seemed 
to be the predominant view in the markets, reflected in a doubling of 
the cost of insuring the US Treasury's own bonds against default. In 
such conditions, the only rational course for savers and investors is 
to pull their money out of all banks or investment funds, whether in 
New York, London, Frankfurt, Hong Kong or Tokyo, and to put every 
spare penny into oil, gold or other commodities that might have some 
lasting value after paper money is totally debased, along with all 
shares, bonds, mortgages and other financial obligations based 
ultimately on nothing more substantial than elaborately printed paper 
signed by politicians and central bankers.

This is more or less what happened on Monday and Tuesday when stock 
markets around the world plunged in response to the US Treasury's 
seemingly unsuccessful attempts to restore confidence in its mortgage 
insurers, while oil hit a record high and gold jumped to within a few 
points of the all-time high that it had reached just before the 
rescue of Bear Stearns and Northern Rock.

But before you conclude that the sky really is falling in and that 
relatively optimistic commentators (including me) have been 
confounded, consider the following. In the past few weeks, US 
industrial production, consumer spending and trade figures have all 
come in much stronger than expected and now point unambiguously to 
accelerating economic growth, rather than a further slowdown. On 
Tuesday the Federal Reserve Board published a sharply upgraded 
estimate of 2008 growth. The near-recession growth range of 0.3 to 
1.2 per cent predicted in April is now seen as a much more 
respectable 1.0 to 1.6 per cent. Even the gloomiest private 
economists on Wall Street now expect second-quarter GDP figures to 
show a strong recovery to growth of around 3 per cent.

Looking at the recent indicators, the clouds are now much darker over 
Britain and the eurozone than the US. The correction in housing, 
which has now been running for almost two years in America, started 
in Europe only a few months ago. The main effects of the slowdown, in 
terms of falling house prices, lost jobs and weak consumer spending, 
are only just starting to be felt in Europe - while in America the 
worst has probably passed. For Britain, the outlook is arguably even 
worse than for the rest of Europe because its economy is so dependent 
on financial services and housing, the sectors suffering the biggest 
hits.

Meanwhile, government spending, the only other sector of the British 
economy growing strongly until a year ago, is also bound to suffer a 
severe squeeze as the public finances go from bad to worse.

Having said all this, however, there is nothing even in the British 
figures to suggest a disaster on the scale expected by most City 
economists - or implied by the recent collapse of shares in British 
banks.

What then is going on? There are two possible explanations for the 
total decoupling between the economic figures and the financial 
markets. The first is that investors are dispassionately analysing 
and forecasting the future, while economists such as myself and, more 
importantly, those at the Fed and the Bank of England, are indulging 
in wishful thinking, based on mechanistic projections from the recent 
past.

The second possibility is the polar opposite - that the financial 
markets are caught up in one of their periodic bouts of emotional, 
straight-line projections of recent losses. Looking at the perverse 
responses to economic news recently in the world's most important 
financial markets, it seems quite plausible that investors today are 
as blind to economic realities as they were in the dot-com bubble, 
the Enron panic and the sub-prime mortgage boom.

But there is another, structural, reason why financial expectations 
may be out of tune with reality - the "hyper-finance" revolution in 
the banking system.

To see what I mean consider the following example. In the old world 
before the arrival of "hyper-finance", if a family wanted a £100,000 
mortgage, they would simply go to the Halifax and borrow £100,000. 
Now consider what happens in the new financial world. The family 
would borrow £100,000 from Northern Rock, which would sell £100,000 
of bonds to hedge funds, which buy these with £100,000 borrowed from 
Bear Stearns, their prime broker, which would raise this money by 
selling £100,000 of commercial paper to Citibank, which would then 
borrow £100,000 through the inter-bank market from Halifax.

So now the original £100,000 mortgage transaction has created 
£500,000 of new debts.

In principle, this entire chain of transactions could be squeezed, 
like a concertina, back to the original £100,000 transaction between 
the householder and Halifax, reducing the total amount of credit in 
the banking system by 80 per cent. This huge reduction in credit 
would do no great harm either to the homeowner or the ultimate 
lender, but eliminating all those intermediate transactions would 
devastate jobs and profits within the banks.

The upshot is that the main people suffering pay cuts and job losses 
in the present crisis are bankers, rather than industrial workers as 
in previous slowdowns.

Not surprisingly, this gives financiers a jaundiced view of the 
world. Nobody can say for sure whether financiers or economists will 
turn out to be right about the present crisis. Past experience 
suggests that financial market expectations are usually wrong at or 
near-cyclical turning points. It is always possible, of course, that 
the present financial panic really will be different from every other 
and will trigger the greatest economic crisis of all time.

But as they say in the markets, the four most expensive words in the 
English language are "this time is different"