On the Today programme on Radio 4 last Thursday, Tim Congdon of Lombard Street Research told me he wouldn’t consider the current state of the financial system worthy of the word crisis.
I was lost for words (it happens, not often, but it happens). For what is this, if it is not a crisis? In the past few months the housing bubble in America has collapsed, as have all the complicated financial instruments related to it (mortgage-backed securities and derivatives).
As a result, banks around the world have announced losses of the kind of scale that befuddle most of us and will continue to do so for many months to come.
Northern Rock (NRK) remains nationalised, in effect, at a cost so far of about £25 billion; the credit markets are paralysed; the central banks have discovered their monetary policy doesn’t work (when they cut their rates, wholesale lending rates don’t budge); and economic growth is slowing across the western world.
Not only is this a crisis of huge proportions but one that is not going to be sorted out in a hurry. The US government is full of plans, which it seems to think can make the problem go away. There’s the plan to freeze interest rates on vulnerable loans and the plan to create the Master Liquidity Enhancement Fund, which will buy up mortgage-backed securities in an attempt to set prices for them and remove uncertainty in the market.
Now there is the new plan to pour £50 billion-odd of new money into the market as cheap and easy loans to the commercial banks to unfreeze the credit markets. The basic idea is that more banks will be able to borrow more money at better interest rates and secure their loans with lower quality collateral.
Is recession less likely in the UK?
I can’t see any of these working, for the simple reason that none of them can solve the problem that kicked off the credit crunch – falling house prices in America – and therefore none of them can stop the US, and probably the UK, falling into recession.
America has been on the verge of recession for some time and some of us think it might already be in one. However, it is usual for even the bears to follow this by saying recession is much less likely in the UK.
This seems odd. Look at how Britain makes money and you would think a recession in the UK is more likely. Why? Because as Chris Wood of CLSA – one of the few analysts who sees things clearly – puts it, our “growth profile is so heavily orientated to housing finance and sub-prime consumer financing”. All those things are coming unstuck.
Why falling house prices matter
The main thing to note on this front is that the housing market has hit what Wood calls an “inflection point”. Prices have peaked and are falling. Mortgage approvals are collapsing (down 12% between September and October), and on Halifax numbers, prices have now fallen for three months in a row.
That’s the first time in 12 years this has happened. Data last week added to the evidence: surveyors said not only that house prices have fallen four months in a row but that they are gloomier about the market than they have been since 1998.
This matters. First because when house prices go up people feel richer and they spend more money. But when they go down people feel poorer and spend less. It also matters because during this cycle rising house prices have not just made people fancy spending, it has given them the means to do so via mortgage-equity withdrawal.
Over the past three years this has added more than 4% to household-spending power, something that has given our economy a significant boost. But it isn’t going to do that any-more; equity withdrawal no longer looks like a clever thing to do, and as house prices fall and mortgage rates rise it should soon fall off a cliff with predictable effects on consumption.
The bulls say this doesn’t matter – they say low unemployment means house prices won’t fall too far and consumption will hold up. This is to see things the wrong way around. Falling consumption – as a result of lower house prices – will surely be the cause of unemployment in our service-based economy rather than a symptom of it.
There was, of course, no sharp rise in unemployment in Japan in the early 1990s, but that did not stop house prices falling fast. Nor did it stop the country slipping in and out of recession for 15 years.
Add this to our strong pound, weak manufacturing base and the rising difficulty of getting credit (at both the corporate and consumer level) and I can’t see how we can avoid recession.
There has been much talk about the resilience of UK markets, but look at the numbers and you will see that there has been no such resilience. The FTSE 100 is very slightly ahead of its January levels but this is almost entirely due to the huge gains made by a few mining companies. Almost all other shares have fallen.
The FTSE 250 index – which doesn’t have any of the big miners – gives us a truer picture of the state of the market. It’s down 15% from its summer highs. And the FTSE Small Cap index? Even worse. It’s off nearly 20%.
I’ve been saying for a while that the UK deserves a bear market. Now it looks like it has one, and given that there is probably a recession around the corner that makes a great deal of sense.
First published in The Sunday Times 16/12/07