The truth about the ‘credit crunch’

The effects of the credit crunch that hit many Western economies in August 2007 are still unfolding. But the start of the New Year provides an opportunity to reflect on the credit crunch’s underlying drivers, and its longer-term consequences for the economy and for wider aspects of global affairs.

The history books are likely to remember the financial happenings of 2007/2008 as the ‘subprime crisis’, referring to the turn in the US mortgage market that precipitated the credit squeeze which then rippled through the Western world. Easy money conditions made funds available to finance millions of US ‘subprime’ borrowers, less well-off people who in earlier times would not have been seen as credit-worthy enough to get a plastic card never mind a home mortgage. These extra homebuyers helped reinforce the pre-existing rise in property prices, producing price hikes in many regional markets across the US. By summer 2007, the market had turned – house prices were falling and default levels were rising.

When the subprime crisis hit, liquidity froze in the wholesale money markets, not just in the US but across the Western world. Most notably, this caused the run on the Northern Rock bank in the UK and its subsequent bail-out by the Bank of England; meanwhile, many financial institutions were forced to take huge investment asset write-downs, causing damage to the balance sheets (and shareholders) of both big high street banks and also international investment banks like Citicorp, Merrill Lynch, UBS and Morgan Stanley.

The precipitate cause for this sequence of events was the cheap and plentiful money that was available to flow into US home-lending (and, incidentally, into many other asset markets too. If the US housing market had survived a bit longer, some other outlet for all this easy money could have imploded instead last year, or this year, or the next. We’d have come to know the turmoil under a different name, but the dynamic would have been similar.)

Following the common pattern of all credit crises, at a certain point – never precisely predictable, because of the ‘elastic’ nature of credit – debt becomes too extended for some borrowers when their circumstances change, default levels begin to grow, and the upward spiral of credit expansion and asset price appreciation turns into its unwelcome opposite. Just as mortgage issuance and rising US house prices fed on each other for several years, so now price falls and mortgage foreclosures reinforce each other.

The difference with the credit crisis this time is that the necessity for writing off the bad debts spreads far beyond the original lenders. The banks and the other institutions which issued the subprime mortgages repackaged the debts and sold them on elsewhere into the financial system. In fact, despite all the commentary about the ingenuity of recent financial innovation, this ‘originate and distribute’ model was not entirely original. The process of passing on debt from one institution to another has long been a feature of the financial markets. A quarter of a century ago, in the 1980s, this activity became so frequent that the terminology of ‘securitisation’ became commonplace, as bank lending was repackaged and sold on as bonds or securities. The same underlying value of a piece of financial paper (or electronic account) becomes reproduced often multiple times elsewhere in the financial system.

In essence, such apparent alchemy, whereby loans are resold as assets to others so that the same underlying value becomes used many times over, is what the credit system has been about since its early days. This time, in fact since the 1980s, the scale and scope of the repackaging of debt was simply more extensive than ever. Hence the emergence of trading in ‘derivatives’ – instruments derived from the original credit note – that dominates modern financial markets trading. More recently, over the past few years, this practice spawned a number of new acronyms which have been a feature of the terminology for today’s crisis: ABSs (asset-backed securities, with the ‘assets’ often being those home mortgages); CDOs (collateralised debt obligations); and SIVs (structured investment vehicles – these are the ‘alternative’ secondary financial bodies which invested in the new mortgage-backed financial instruments).

The more extensive way that the original debts were rebundled and sold on – ‘sliced and diced’, as it became known – was initially applauded as a way of spreading the risks if and when any of the original debts went bad. The thinking was that if the potential problem loans were spread widely enough across a range of disparate organisations, no one financial institution would be seriously impacted. The problem was that this repeated transfer of risks to others came at the price of no one knowing who eventually was left holding the original subprime loans. The supposed benefits from risk transfer turned into its opposite: contamination. Every financial holding became potentially suspect. No one was – and no one still is – sure who holds all those subprime mortgages, and therefore who will bear the ultimate losses estimated at between $200 and $500 billion.

To date, investment banks have taken about $80 billion of write-downs, so it appears there is a lot more to be identified and recognised publicly. It is this uncertainty that led to the freezing of the wholesale money markets. Banks held on to whatever money they had to bolster their own balance sheets in the event of any of their assets becoming devalued; and even banks with surplus liquidity were, and remain, wary of lending it on because they do not know if the borrowing institutions are genuinely solvent enough to pay it back to them later.

The twin drivers of ‘easy liquidity’

The latest period of easy credit has been of unusual scale and duration because it was supported by the coincidence of two novel factors. One arose from troubles in the West, the other from the rise of the economies of the East. The former held back demand for liquidity due to a weakness in productive investment, while the latter contributed additional supplies of liquidity derived from all the extra values being created in the rapidly developing parts of the world.

Many Western countries, and in particular Britain and the US, have seen their economies turn ‘SAD’. Since the late 1980s, these economies have been characterised by their Stability, Anaemia and Durability. They have been stable in the sense that their cycles have not been given to extremes of economic dynamism or weakness. The upturns have never been that buoyant (the early 1990s and early 2000s) and the recessions never that severe or destructive (in 1990/1991 and 2001/2002) – some countries avoided a technical recession (two quarters of output contraction) completely earlier this decade. Instead, these economies have grown at a fairly steady, modest pace for most of these 20 years.

They have been anaemic in the sense that they have lacked the vitality produced by sustained investments in productive capacity. Outside the high-profile instance of IT spending and innovation, driven primarily out of California, industrial investment has also been of a modest scale across the Western economies. This lethargy in capital investment does not necessarily cause immediate economic problems, but over the longer term it saps the underlying basis for innovation and industrial renewal necessary for sustained economic vibrancy and dynamism.

The third linked aspect of recent economic history is the durability of this steady, modest growth even when confronted by disruptive challenges. The reasons for this resilience and flexibility are partly due to the stable domestic industrial and political relations of the past two decades, and partly result from the favourable international environment, usually described as a new age of globalisation. The combined effect is that Western capitalism has proved remarkably resilient and adaptive in the face of a succession of global crises.

Their economies were impacted only temporarily, and to a quite limited extent, by, for example, the Asian financial crisis of 1997, by the Russian debt default and implosion of the hedge fund Long Term Capital Management in 1988, and by the bursting of the DotCom bubble in 2000/2001 (the latter was also as much a financial bubble in the stock markets as it was a burst of technological change). Even the shock to the Western psyche of the 9/11 attacks in the US did not produce the dire economic slowdown that many feared at the time.

One feature of these SAD economies is that while new values are made or secured by Western companies, both financial and non-financial, these resources are not all required for domestic productive investments and restructuring. This imbalance in domestic circumstances has been one of the important drivers for the unusual amount of liquidity available to flow around the financial markets.

The second factor, which incidentally is one of the material foundations for what is commonly described as globalisation, is the era-defining explosion in production and value creation in China, India and other parts of Asia. Partly due to the early stages of internal development in many of these countries, and partly due to the desire to build up the cushion of substantial foreign exchange reserves, huge quantities of funds have been made available for supporting financial liquidity across the world.

Expressive of this liquidity driver, attention in recent years has focused on the rapid accumulation of China’s foreign exchange reserves, which now top $1.5 trillion. Most of these funds have made their way into US securities, including repeated huge purchases of Treasury bonds, which have helped keep down long-term interest rates, an indicator of easy credit conditions. A more recent expression of this source of liquidity from the old Third (and Second) World is the rise of the Sovereign Wealth Funds. These government-backed investment vehicles, which derive their money from their country’s foreign exchange reserves, have expanded many times over in the past few years – reaching a value of around $4 trillion today, with projections for rising to $10 trillion within a few more years.

Funds run by Russia, Singapore, Abu Dhabi and, of course, China, and several other Asian and oil-producing countries, have been buying prominent stakes in leading Western businesses, including banks. This represents a reversal of the conventionally assumed direction of capital flows between East and West, and reinforces the eastern dynamic for global liquidity for a long time to come.

Five lessons from the credit crunch

1) The financialisation of the Western economies will continue long after today’s credit crisis fades.

Many commentators have argued that the experience from today’s credit crunch will put an end to the more outlandish forms of recent financial activity and the use of some of the more exotic financial instruments and complex instances of derivative issuance. No doubt this is true – for example, lenders will be shy in offering subprime mortgages for a time to come, and those SIVs will fall from favour. However, there won’t be any reversal of the onward tide of financialisation, in the sense of the increasing dependency of Western economies on financial as opposed to production activities. This trend away from production is now well embedded. On the other hand, those twin sources of global liquidity will not be diminished by the credit squeeze and will find new outlets in the years to come.

The onward march of financialisation also means there will be more financial crises to come, making their appearance in some other part of the derivatives market. Risk managers and regulators are like the proverbial generals who are good at fighting past wars, but rarely anticipate the next. In future crises we will doubtless have to get to grips with new financial acronyms of which most of us are currently unaware, or which may not yet exist.

2) The implications of this credit crisis are both less and more serious than is generally recognised.

It is less serious because of the greater resilience and durability of the Western economies, as described above. Just as they withstood the effects of previous financial crises, so they will cope with the subprime crisis, too. The consequences will also be less serious than many have predicted in that the real economic impact is going to be mediated primarily through the sphere of consumption rather than production. In the past, more than 20 years ago, economic slowdowns and recessions were driven by the onset of problems in industry and production. Fundamental problems in maintaining consistent and adequate levels of profitability led to periodic breakdowns within production, and necessitated subsequent bouts of industrial restructuring to get the economy moving again.

In the past, the impact on consumption levels was derivative to these problems in the area of production. Similarly, most financial crises in the past were byproducts of production crises. For example, the 1929 Wall Street crash, which was perceived to precipitate the 1930s Depression, was in fact itself the consequence of mounting difficulties of the profitability of American businesses during the latter third of the 1920s.

More recently, including currently, the direction of effects is the opposite – starting with finance and then moving to depress consumption, and only subsequently, as a derivative of this sequence, impacting on industry and production. This is why many individual businesses today, in, for example, the UK manufacturing sector producing for other businesses, are anticipating a reasonable future despite the credit crunch (1). Anticipations today of a return to a 1970s-style recession in the wake of the credit crunch, and by some even to a 1930s-style Depression, are therefore hugely misplaced.

However, while fears of severe slowdown are overdone, the specifics of this credit crunch also highlight the more serious plight facing Western economies. Their dependence on financial activities and on credit-fuelled consumption expresses a hollowing out of the core mass of production that used to drive their economies forward. These economies lack an essential substance at their heart and will become increasingly parasitic on events and developments outside of their direct control. This is nowhere better illustrated than within the British economy…

3) The UK economy could be the worst hit of all by the fallout from the credit crunch.

Few people are reassured by the frequent assertions from UK prime minister Gordon Brown, and his chancellor of the exchequer Alistair Darling, that the UK economy is ‘fundamentally strong’. Doubtless this scepticism is more often the result of a generalised distrust of politicians in our age, of political disengagement and disenchantment, than it is based on the specific detail of the British national economy. (Incidentally, in similar vein, the run on the Northern Rock bank in September, when thousands queued to withdraw their funds, was precipitated more by the government claim that there was ‘no need to worry’ than it was by an appreciation of the particular funding model used by Northern Rock, which made it especially, though not uniquely, vulnerable in a wholesale money market freeze.)

Nevertheless, this scepticism is justified if we understand ‘fundamentals’ as referring to a solid core of productive capacity underpinning the economy through good times and bad. The consequences of the credit crunch should highlight the dependence of British economic activity on three limited sources: credit-fuelled consumption reinforced by rising house prices, public spending, and the financial and business services sector.

The credit squeeze will undermine the buoyancy of consumption as people borrow less either through equity withdrawal on their homes or via more conventional credit card borrowing and personal debt. Since measures of GDP growth have been disproportionately reliant on consumption spending rather than business investment over recent years, this influence will fall away or even go into reverse. Hence the worries being voiced by many retailers and by what’s left of the domestic consumer goods industries.

Meanwhile, the momentum provided by the financial and business services sector is bound to be held back, at least temporarily. This combined sector now contributes about 30 per cent of GDP and has provided much of the growth in national output in recent years. With the City of London simultaneously central to the health of GDP, and to the world’s flows of finance, this recent boon to the UK economy becomes its Achilles’ heel in a credit crisis. With lending levels and derivatives activity reduced, there is less to be earned in commissions, fees and interest spreads. This driver of the economy becomes a brake.

Finally, it will be difficult for public spending to sustain its recent contribution to economic expansion, never mind compensate for the slowdown in classical Keynesian pump priming fashion. The government is close to its self-imposed borrowing levels – though no doubt it will find new ways to bend the Treasury rules here in traditional New Labour manner – but the fact that it is running the biggest public budget deficit ever in the first eight months of the financial year is a practical constraint. The fall in tax revenues precipitated by the triple whammy of a slowdown in retail spending, a more restrained housing market, and lower profits and personal bonuses earned within the financial services sector will exacerbate the limits on public spending and its potential for supporting the economy at a time when it is more needed than ever.

The medium-term prospects for the British economy will depend once again on its capacity to cope with domestic slowdown by adapting to the opportunities available in the international arena. The rump of British manufacturing may well be helped by seeing its export competitiveness supported by a falling currency, but, more importantly, the future for the British economy will continue to depend on the way the financial and business sectors make money from their overseas operations, and, in particular, from the exciting economic happenings in the East.

4) The machinery of the state continues to play a crucial economic role across the Western world.

The hubbub of anarchic wheeling and dealing that gives us our image of what happens on the floors of the stock exchanges makes the financial markets appear as the most untarnished instance of free-market capitalism. In reality, this area of economic activity has seen as much, if not more, new regulation than any other in the past couple of decades, concomitant with its increasingly central role in Western economies. State intervention both influenced the form of this credit crisis and dominated the reactions to it.

For example, the key recent role of the SIVs as ‘shadow’ banks was partly a way for mainstream banks to operate ‘off balance sheet’, and away from the gaze of the regulatory authorities. And when the crunch hit, the state had to intervene more directly; in the UK the government had to sanction bailing out Northern Rock and its depositors to the tune of over £20 billion. Meanwhile, the absence of Northern Rock-style collapses in the US – paradoxical given this was where the crisis originated – is testimony to the support provided by the state authorities there in the form of the little-known Federal Home Loan Bank (FHLB) system. As financial columnist Gillian Tett explained, ‘What the FHLB essentially does is raise money cheaply, by virtue of having an implicit state guarantee. It then uses this to provide loans to other financial institutions’, that is, to the US equivalents of Northern Rock who similarly found they were unable to fund themselves in the normal way through the capital markets. Hence, as Tett goes on, ‘when the global mortgage securitisation market suddenly froze up this summer, Northern Rock belatedly discovered that it could not readily tap state alternatives, unlike its counterparts in the Land of the Free’ (2).

Even in the absence of effective intervention, the shadow of the state remained ever present over the credit crisis. Among the major central banks, the Bank of England is generally perceived to have done the worst job handling the effects of the crisis. Although the differences between them were not that great – the European Central Bank and the US Federal Reserve have had their critics, too – the Bank of England did have an extra challenge due to the particular regulatory apparatus it had to work with resulting from previous state intervention.

In his defence, Mervyn King, the Bank of England’s governor, made a fair point in explaining that the UK regulatory regime undermined an early response to the onset of the credit squeeze. An ill-defined division of regulatory responsibilities between the trio of the Treasury, the Bank of England and the Financial Services Authority did add to the sense of uncertainty and passivity of the UK state’s response in the early weeks of the credit squeeze over the summer. Ironically, this unclarity of supervisory and action roles between the three institutions was a byproduct of what is often described as Gordon Brown’s single most effective policy measure in government: granting the Bank of England independence in 1997.

So both by what it has done and by what it failed in doing, the dependence of financial operations on the activities of the state were highlighted. It is worth adding that Governor King also missed the key point in implying that a further technical regulatory fix would make remedial action more effective in a future financial crisis. Regulatory extension, and the frequent unintended and counterproductive consequences that result, is the other side of the coin of the vacuity of purpose and vision within Western authorities, and the indecision that accompanies this. In our age of generalised anxiety, extra regulation and haphazard state responses feed on each other. This is the fundamental reason why the collective responses to this credit crisis have been more lacklustre, less coherent and effective than the admittedly far from perfect instances of economic crisis management in previous times.

State influence remains pervasive in financial and other economic markets, even if the state works less well than it used to, operating in a more arbitrary and a less consistent and purposeful fashion. This lesson of continuing, in some ways deepening, state dependence provides another reality check to set against the myth of a neo-liberal market revival over the past two decades.

5) These troubles in Western financial markets provide another opportunity for the East to extend its economic and political influence in the world.

We are in the early stages of an era where there will be a rebalancing of the world from the old West – exemplified by the US acting for most of the past half-century both as the world’s policeman and economic powerhouse – to the new East – exemplified by the rise of China and India, with Russia, Brazil and Argentina honorary members of the ‘East’ (just as Japan is often lumped in as a member of the ‘West’). The transfer of power arising from decisive shifts in underlying economic weights is never smooth and steady, even though the direction of change is relentless. Old powers never want to give up their position, while the aspiring ones need time to find their way and test their new capabilities and roles.

Crises, including mini-crises such as this credit crunch, provide occasions for the rebalancing to move a little further both in reality and, perhaps more importantly at this relatively early stage, in perception. Chinese and other Asian investment funds have taken the opportunities brought about by the difficulties the crisis has created for Western banks to buy stakes in Merrill Lynch, Citigroup, UBS, Bear Stearns and Morgan Stanley. This gives the new economies more influence in global affairs and a way to accelerate the development of their own expertise. Buying and building is a good answer to that traditional Western business question: ‘Build or buy?’

Even more striking than these Asian initiatives is the way that China and the East in general appear to have been unaffected by the credit crunch. In the past, the aphorism was that when the US sneezes, the rest of the world catches a cold. This time the discussion is about ‘decoupling’ – how the fortunes of the Eastern countries are separated from those of the West, and now have their own autonomous dynamic. As a symptom of this new thinking, Asian stock markets and economic growth forecasts have been barely impacted over the past half-year since the credit squeeze began.

In reality, the claim of ‘decoupling’ is overstated – when American and European consumption slows, Asian export markets will be hit with a noticeable impact on their overall pace of output growth. Despite strengthening regional spheres of activity, the global economy remains interconnected in multiple ways. No country is yet immune to US difficulties. This is more than a short-term challenge; the credit crunch may mark the end of the times when the world economy could rely on US consumption as one of its main engines of growth.

However, what is indisputable now is that the label of ‘emerging market’ is becoming outdated for more and more of the old Third World. The ‘BRIC’ economies of Brazil, Russia, India and China have successfully moved through their early fragile stages of autonomous development. They have established an independent dynamic which will allow them to cope adequately with Western financial, and even economic, turbulence and avoid serious domestic disruption. They will still have to endure more of their own growing pains in the years to come, but the era of their abject economic subservience to the West is over.

The story for the next year in Western financial markets will be of the further repercussions of the credit squeeze. Meanwhile, the story for the next generation is of the rise of China and the rest of the East, and of the way that Western troubles become Eastern opportunities.

Phil Mullan is the author of The Imaginary Time Bomb: Why an Ageing Population Is Not a Social Problem, IB Tauris, 2000 (buy this book from Amazon (UK) or Amazon (USA)).

(1) See ‘Producers plan for growth next year. Rosy outlook for inter business trade’, Financial Times, 27 December 2007

(2) Financial Times, 21 December 2007