Nothing much changes in financial markets. In 1907, a crisis following a long period of economic expansion prompted calls for the authorities to restore order. A century on, in similar circumstances, America’s Federal Reserve has duly stepped in, cutting the discount rate (at which banks can borrow from the Fed) by 0.5% to 5.75%.
By making it easier to borrow, the Fed, the traditional lender of last resort, stepped up its attempts to inject liquidity into the system, says Capital Economics. Along with other central banks, it had previously simply been adding liquidity to the interbank market, which had seized up amid uncertainty over which banks were exposed to subprime-mortgage securities. The move boosted equity markets late last week after a scramble for safety saw both the FTSE 100 and the Nikkei 225 record their biggest daily falls since September 11th 2001 – 5.4% and 4% respectively; UK blue-chips promptly rocketed by their highest daily tally since March 2003.
Equity markets recovered because they saw the move as the prelude to a cut in the main US interest rate. But the money markets have continued fleeing to safety. This Monday, the yield on the three-month Treasury bond slumped by another 1.2% – faster even than during the crash of 1987 (although it rebounded by almost 0.5% the next day as hopes for a rate cut grew). Matters have hardly been helped by large losses at two more big US mortgage lenders and another German bank bail-out. No wonder investors have lost confidence in asset-backed loans and bonds. Veteran investor Marc Faber says the excesses of this credit bubble, “both in terms of quantity and low quality”, dwarf those of the 1920s bubble.
But a vital issue for investors now is what effect financial-market turmoil will have on the broader economy; the Fed notes that risks to growth “have increased appreciably”. Indeed, there’s a good chance of a “full-blown economic crisis”, says Breakingviews’s Edward Chancellor: the credit boom has gone on for “five frenetic years and virtually everyone has become involved”.
One way the financial turmoil can hit the economy is through consumption, the main component of GDP. As Lex points out in the FT, spending has been underpinned by rising property and equity prices, so further falls in these markets will dent spending. US housing is set for further pain as two million mortgages with adjustable rates are due to be reset upwards, says Ambrose Evans-Pritchard in The Daily Telegraph; the lowest car sales in nine years last month – “the credit crunch has engulfed auto loans” – show consumers are already wilting.
More broadly, with credit less readily available, debt-fuelled spending will be undermined. Cautious UK subprime lenders are preparing to raise their mortgage interest rates, implying a further property-market slowdown. Higher borrowing costs would also affect companies’ capital expenditure and hiring – with a downturn in the latter in turn endangering consumption. Edward Hadas on Breakingviews estimates that an end to easy credit forebodes a “big markdown” in the profits of companies comprising half the developed world’s market capitalisation.
A particular problem in the UK is that London and the Square Mile account for around 30% of GDP growth. With many financial firms now likely to take a hit, corporation tax receipts are set to fall. Sliding equity markets presage a lower stamp-duty take, which is unlikely to be offset by a robust housing market, says Robert Watts in The Sunday Telegraph. The Government relies on buoyant markets for billions of pounds in tax; according to one think tank, the past two weeks could cost the Treasury £3bn. With scant fiscal room for manoeuvre, taxes may rise. As The Guardian says, “bad times for the rocket scientists of finance” mean bad times for all of us.
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