Bill Jamieson: Cut us some slack on interest

Published on Saturday 4 October 2008 13:42

EMERGENCY bank bailouts. Emergency bank rescues. Emergency deposit guarantees. And coming with a force incredible: emergency summits, emergency interest rate cuts – and, soon after, emergency national budgets.

We have moved, in the space of barely a month, from a state of apprehension over financial markets to a sweeping global downturn. The crisis in capital markets has now spilled over into the real economy with a vengeance. The resort to emergency action is no longer about cushioning a mild slowdown but a scramble to prevent non-government economic activity grinding to a halt. Such is the speed and force of the crisis worldwide that the knock-on effects compel action by the Bank of England this week, the US Federal Reserve quite possibly and the European Central Bank soon after.

As money markets have seized up, central banks worldwide have been transformed from lenders of last resort to lenders of first resort. The swap lines of the US Federal Reserve with foreign central banks was more than doubled on Monday to $620bn. Both the Bank of England and the European Central Bank have also been pumping massive amounts of liquidity into the money markets.

Governments around the world are scrambling to prop up their banking systems. Some are doing it on a case-by-case basis. Others, like Ireland and Greece, are expanding guarantees to depositors and acting as buyers of last resort of troubled assets. The European single market is in mayhem. The Irish action has sparked apprehension among governments that have so far not acted to improve protection for their own depositors lest their own banking systems be drained.

Even as the US administration's $700bn bailout plan was being passed by the House of Representatives on Friday night, news from America's real economy made clear that recession is now underway. Factory orders in August tumbled by 4% on July levels. And unemployment has shot to a seven-year high.

The weakness in US new home sales is no longer about affordability. And the drop in car sales is no longer about record oil prices. Rather, the ongoing recession in both is increasingly due to the credit crunch and the lack of available credit. Would-be buyers simply can't get the mortgage and car loans they need to make their purchases.

The odds of a short and shallow recession are diminishing fast. This increases the odds that the Fed will cut the federal funds rate again, perhaps by 50 basis points, at the next meeting of its interest rate setting committee on October 28-29.

In Europe, France has joined Ireland in recession. Other EU economies are either already in recession or destined to follow. Five European banks failed in one day last week and Britain has been scrambling to stave off a crisis of confidence at some of its biggest banks in the wake of the Bradford & Bingley collapse and nationalisation.

So far, not one depositor in a British bank has lost a penny, Adair Turner, the Financial Services Authority's new chief executive, proudly declared on the BBC's Newsnight last week. But that doesn't mean savers have not been hit. Everyone saving for retirement through a pension plan has suffered through the sharp fall in stock markets. Tens of thousands of small shareholders in demutualised building societies have seen their nest eggs wiped out entirely. Shareholders in HBOS – there are 2.1 million of those – have seen their shares plunge by more than 70% in the past year. Investors in RBS have fared little better. These are FTSE-100 companies, held indirectly by millions of people through unit trusts and ISA savings plans. "Let the shareholders go hang" has been the populist cry – with all too little realisation of who the ultimate victims are and how they will suffer.

In Britain the crisis is spreading from the housing sector across the real economy. Of particular concern is the tightening of credit availability for business borrowers. The latest Bank of England credit conditions survey throws a stark spotlight on the link between the credit market crisis and the real economy. It shows tightening lending standards, weak credit demand and rising defaults. It also highlights the vicious circle now at work, with banks cutting back on lending to companies and households because of the worsening economic outlook, a reduced appetite for risk and reduced availability of funds. In turn, the reduction in the supply of credit exacerbates the downturn – which will reinforce the reluctance of bank to lend in coming quarters. It is notable that banks report that reduced investment spending is a major factor in the downturn in demand for credit from companies, highlighting the downturn in capital spending.

Last Friday brought an appalling Chartered Institute of Purchasing Managers survey on the service sector, showing activity and employment last month contracting for a fifth successive month and at the fastest rate since the series began in mid-1996.

The sharp fall in incoming new business, weak business expectations and record low backlogs of work point to further very weak activity ahead. This does not bode well for consumer confidence and spending. And it almost certainly puts an "emergency" interest rate cut on the cards this week. Indeed, the only debate is whether it will be 0.25% or 0.5%. Given the glacial way in which the Bank has responded to this developing crisis since last autumn, a 0.5% cut to 4.5% is too much to hope for. But that is what is necessary – and followed quickly by further cuts. A quarter point cut in current conditions would be useless.

Even more glacial has been the response of the European Central Bank, though it signalled last week that it is no longer in tightening mode and may even cut rates next month. This lofty insouciance to the deepening crisis across the EU almost beggars belief. This weekend has seen an emergency crisis summit of Europe's four Group of Eight member states in Paris to try to hammer out a united European strategy to overcome the crisis.

The dismal data on America's economy has sent shares tumbling in Tokyo and across the Far East on fears that a recession in the world's biggest market for consumer and household goods will mean a global slump. The Tokyo Nikkei is at its lowest since May 1995. Even though the rescue package by US Treasury secretary Henry Paulson was passed, investors around the world are increasingly pessimistic about the outlook for the US economy.

Will the Paulson Plan make much difference if banking systems in the US and Europe are already on life support from their respective central banks? Now that recession has set in, banking counter-parties have many reasons to distrust each other beyond those relating to US mortgages.

We have come a long way in a short time. Just a few months ago it seemed the US might avoid a recession. Europe's political class was convinced the crisis had nothing to do with them. As for the UK, the Government assured us we were better placed than anybody. This is the same government that has now had to nationalise two banks, waive competition rules to secure the rescue of another, and which has just upped the deposit guarantee scheme to 50,000. Previous assurances have proved delusional. And the sharp rise in government borrowing now points to the November Pre-Budget Report preparing the way for an emergency budget next year. All the emergency actions we have seen or are about to see point to a disconcerting truth: we have crossed a Rubicon.