Somehow or other, I contrived to be away for all the summer’s most exciting moments. I was on holiday in July in the week of the floods, when the credit crisis first rocked markets. I was away again in August, when the money markets froze and the European Central Bank and US Fed had to come to the rescue of the banking system. And last week, I was in such a remote part of the Scottish Highlands that the only way I would have known of the turmoil in the three-month money market was if someone had gone out in a helicopter looking for me.
On the days when I deigned to visit the office, I certainly picked up on the nervousness, bordering on panic, in the voices of bankers, traders and hedge-fund managers – and thank goodness I did, because otherwise, coming back to work this week, I’d have struggled to know what the fuss was about. The stockmarket is back where it stood in mid-July, interest rates are unchanged, the pound is barely changed against the dollar and euro, commodity prices are still sky-high and even credit spreads – the premium over base rates that corporate borrowers must pay for their loans – are merely back to 2003 levels. Hardly much evidence of disaster.
Yet the world clearly has changed over the summer – and there is still plenty that can go wrong. There’s $120bn of commercial paper that needs to be refinanced over the next few weeks; there’s the $1.2trn of bank exposure to conduits and other structured investment vehicles – supposedly low-risk funds operating under bank guarantees – which might have to be brought on to balance sheets; there’s the stalled pipeline of leveraged loans that investment banks still hope to disgorge on to the markets; and there’s the mystery of what losses banks may be forced to declare as a result of writing down assets on their trading books.
All these threaten to choke off the supply of credit not just within the banking system, but also to the real economy. And these are just the problems we know about. I’ve been shocked over the last few weeks by the number of very senior people in the City who have admitted to me they knew next to nothing about conduits, SIVs, SIV-lites and the other murky structures at the heart of this crisis. According to private-equity grandee Jon Moulton, this ignorance extended even to senior figures at the Bank of England, which is supposed to be responsible for financial stability. So who knows what further horrors lurk in so far unexplored dark recesses of the credit markets?
In this environment, anyone who claims to know all the answers clearly doesn’t understand the question. As one of London’s shrewder hedge-fund managers said to me this week, it’s impossible to say how this will play out: everything hinges on the policy responses of central banks and regulators. Get it right, as the Fed arguably did in 1998 and 2001, and the markets will bounce back, without the need for any lasting recession. Get it wrong, as the Fed and US government most spectacularly did in the 1930s, and the consequences could be devastating.
But what are the right policy responses? Alan Greenspan reportedly told a City dinner last month that central bankers need to approach this sort of crisis not as economists, but as psychologists. There’s no doubt what the market wants: a half percentage point US interest-rate cut – and equity markets, in particular, are betting they will get it. But there are big risks here for the Fed. Disappoint the markets and share prices could tumble, mortgage defaults will continue to rise and a new round of credit-market turmoil may emerge. But give in to the markets, and the dollar may tumble, inflation may pick up and the Fed may be left with an economic – as opposed to financial – crisis on its hands. And that’s on top of the appalling signal it would send to the markets, if the Fed were to bail out the banks for their mistakes.
I’ve no idea which way Fed chairman Ben Bernanke will leap. But one thing that’s clear is that the UK is uniquely vulnerable to what he decides. Britain is more indebted, more exposed to financial services and more reliant on consumer spending to keep our economy going. Already, the credit crunch seems to be leading to higher borrowing costs and tighter lending standards for companies and homeowners, while the strong pound is hitting exports. A downturn in the City, with job losses and lower bonuses, will remove an important source of demand from the domestic economy. Any slowdown could be made even worse if the armies of immigrants over the last few years decided to drift away again.
The economic openness that has served us so well in recent years could count against us in the downturn. That could hurt, and may undermine support for our unique brand of free-market capitalism. But keeping our markets open will also be the secret to our ability to bounce back. So while all eyes over the next few weeks will be on the Fed, British policy-makers have a big role to play too.