The recession staring us in the face was always going to be a bad one – booms can only turn to busts. But add into the mix a banking system that needs to cut back sharply on lending and what could have been a normalish recession will turn into an extended one.
Banks cutting back on lending will constrain house prices and consumer spending on credit, tipping over-borrowed firms into bankruptcy. But while no one is going to enjoy the next few years, we should note that this isn’t going to be as bad as the 1930s, nor even as bad as either of the two oil crises of 1974 and 1980. When Darling said the outlook was worse than anytime for the last 60 years, he was exaggerating.
America was already in recession (not officially, but quite clearly) and Britain was heading into recession before the banking bailout package announced in the last two weeks. The banks were over-stretched, with too many loans and risky mortgage securities for their capital bases. Such an over-leveraged position looked fine when things were good, but when the US economy started to roll over into a recessionary down-cycle, the very first and most vulnerable part of the Western banks’ asset base, US sub-prime borrowers, naturally started to default. So this didn’t start as a subprime crisis, but an under-capitalised bank crisis with subprime just the weakest link in the chain. As soon as the economy turned down, the banks’ vulnerability was going to be exposed.
Still, even accepting that this is going to be bad and that the banks will probably be forcing bankruptcies and precautionary savings by consumers for the next four to five years (if the 117 previous systemic banking crises the world has seen since the 1970s are anything to go by), it isn’t likely to be worse than 1980 or even 1974, let alone the Great Depression. Here’s why.
First, let’s take the two oil crises. Western economies were much more dependent on oil back in the 1970s. Since then we’ve boosted other forms of power generation and our economies have become more service- and intellectual-property-related and less manufacturing- and transport-dependent. So it’s hard for us to appreciate the more devastating impact that Opec, which accounted for far more of the world’s oil production back then, caused with its unilateral imposition of production quotas and sharply higher oil prices.
The oil crises came out of the blue at the end of the 1960s, at a time when inflation had already been running in the 6%-10% range and rising prices had already got into the wage-bargaining system. This was made worse by the secondary-sector nature of the economy. The manufacturing and transport industries were heavily unionised and powerful enough to demand high wage settlements. The world of strikes and bankruptcy-inducing pay settlements was born. Exogenous (external to the economy) oil-price shocks aren’t inflationary unless they get into wages, so we don’t have the same problems this time around – real wages in the US and UK are falling, not rising. We’re also less dependent on oil than we once were.
So it’s important to realise that today the impact of such exogenous shocks, even though they include higher oil prices, is actually deflationary, however counter-intuitive that may sound. If you think of the higher oil price as a tax, but one imposed on us by a foreign power (so we get no benefit from the spending of those tax receipts) then it’s easier to see how, on their own, higher oil prices just suck expenditure out of other areas and push prices in those areas down. The oil price is now falling back, but the damage is done – this was a deflationary, not an inflationary shock.
The under-capitalised banking system also has a deflationary impact and is an endogenous (internal to the economy) shock. Endogenous shocks are much better than exogenous ones because we can do something to solve the crisis. Luckily for us there have been so many such banking bailouts in the past that the authorities also know what to do (however much Gordon Brown tries to pretend he made the present solution up all by himself).
And what about the 1930s? Back then the US authorities were much less familiar with what to do in such situations, so they tried a three-pronged approach, which led to disaster. First they put up trade barriers, second they actually raised interest rates to shore up the currency, and third they left the banks to deal with the problem on their own. Skipping capital injections saved the US government a lot of money in the short term, but the price in terms of lost GDP output was appalling. Thirty percent was wiped out and a depression was born. Hopefully you will not see the US or any other government trying a single one of those disastrous policy actions. We have learnt at history’s expense what not to do. Which should mean that our recession, while nasty, does not turn into a depression.
• James Ferguson is chief strategist at Pali International