Banks may be safe, but what about us?

Prime Minister Gordon Brown's rescue plan was widely welcomed at first, but then came a reality check; however many billions are poured in, we will still face a global recession. Heather Stewart reports

* Heather Stewart
* The Observer,
* Sunday October 19 2008
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* Article history

Gordon Brown and Alistair Darling must have congratulated themselves last Monday morning as share prices across the world rocketed. After hours of adrenaline-fuelled late-night talks with Britain's cash-strapped banks, the Treasury had hammered out a £37bn bail-out plan and Brown had persuaded leaders across Europe and the US to follow suit.

But just 48 hours after greeting the Brown proposal with heady euphoria, financial markets swung back into a dangerously black mood. Traders had been focused on the threat of a total collapse of the world's financial system - what IMF managing director Dominique Strauss-Kahn called 'meltdown'; but once that fear had been eliminated, with the promise of massive government intervention, investors began fretting about the next worst possibility - a long, painful recession.

Gloomy unemployment figures released in Britain last Wednesday morning and, later, news that retail sales in the US had fallen by 1.2 per cent in September, the third successive month of declines, switched the focus firmly back to the economy. At the same time, UK banks raised questions about the conditions Darling had imposed on the bail-out deal to ensure taxpayers got their money's worth. The brief bout of exuberance dissipated and a fearsome sell-off got under way. By the end of the week, the markets had made up some of the lost ground, with Wall Street and the FTSE ending Friday on a calmer note, and veteran investor Warren Buffett saying there were bargains to be had; but no one was under any illusion about the sickly health of the world's economies.

When shaken G7 finance ministers signed up to the principle of bailing out their banking systems in Washington last weekend, they knew their actions would be too little, too late to prevent the financial turmoil from sparking a worldwide economic crisis. As Ben Bernanke, the cerebral professor in charge of the Federal Reserve, put it in a speech on Wednesday: 'Stabilisation of the financial markets is a critical first step, but even if they stabilise as we hope they will, broader economic recovery will not happen right away.'

John Higgins, senior market economist at consultancy Capital Economics, says the markets should settle down but that will not be the end of the story: 'We do think that what's happened over the past week is a watershed, but the key point is not to confuse bank recapitalisation with economic recovery.'

Brown may be chary of mentioning the 'R-word' - recession - but there is a growing consensus among economists that in the UK and much of Europe, one is already well under way. Russell Jones, senior strategist at RBC Capital Markets, says the second half of this year, and the first half of next, are looking, 'distinctly recessionary' in the US too, as the grim cocktail of tighter credit and shattered consumer confidence take their toll.

Research by analysts at Credit Suisse on the usual characteristics of recessions in Europe and the UK shows they tend to be long - lasting an average of almost two years - and involve a sharp rise in unemployment. It adds that Britain's spendthrift consumers are entering this particular downturn in a much worse financial state than their eurozone counterparts, with large debts and few savings tucked away for impending rainy days.

Banks may no longer be about to go bust, but even with government support they are likely to be cutting back on lending - and consumers and firms are now so nervous about the future that there may be few takers for loans anyway.

As one indication of the devastation that can be wrought on economies when it gets harder to borrow, Jones points to 1979, when the Carter administration in the US introduced direct controls on lending to rein in a booming economy. Activity collapsed, as firms and families struggled to get loans. Output in the following quarter plunged at an annual rate of 7.8 per cent, making it the weakest three months since the Great Depression. 'That gives you some idea what happens when the credit tap turns off,' Jones says. 'This kind of dysfunction can have a huge impact.'

Six months ago, economists were hopefully clinging to 'decoupling', the idea that rising powers such as China and India would carry the torch, even as the US and Europe slipped into recession. The oil price continued to soar, as though, despite a looming downturn in the US, still the world's biggest consumer of crude, consumption would be held up by China's insatiable appetite.

But the longer the financial turmoil has continued, the wider its effects have spread, and the harder it has become for any economy to escape. The oil price has plunged in the past month, dipping below $70 a barrel last week, as it finally dawned on investors that, just like the price of property and shares, commodities had experienced an unsustainable bubble.

By next year, the IMF now expects economies everywhere to have caught the West's cold, with the only hotspots in Africa, and some of the less exposed South American economies.

In Geneva, last Thursday, the UN's development arm, Unctad, warned that many developing countries were now concerned they would be in the firing line, without the resources to prop up their own banks and rescue their economies from deep recession.

'The impact on developing countries will be much deeper than was anticipated,' says Supachai Panitchpakdi, the former World Trade Organisation boss who is now head of Unctad. Perhaps most alarmingly, there are growing fears about the health of China. When Beijing copied the co-ordinated rate cut by other central banks on 8 October, it was seen as a gesture of solidarity, a sign that China was keen to join the international onslaught on the crisis. But analysts say it was also a genuine attempt to offset the hit to exports, as US consumers, who have sucked in billions of dollars' worth of cut-price Chinese goods, tighten their belts.

Tom Albanese, boss of the mining giant Rio Tinto, sparked widespread alarm in the markets last Wednesday, when he warned that he expected China to be 'pausing for breath' in the next 12 months. Optimists say this 'pause' will be an ideal opportunity for China to carry out a long-awaited rebalancing, from heavy dependence on exports, to generating its own virtuous circle of growth through demand at home. Pessimists warn that if you take the impetus of strong global growth away, China could suffer badly.

Globalisation and the internet were meant to usher in the 'weightless economy' as developing countries competed to provide cheap services across the globe. But exporting old-fashioned goods also remains crucial to the success of many developing countries.

For some, the credit crunch will mean full-blown financial crisis. So far, Iceland has provided the most graphic illustration of what happens to an economy when financial boom turns to bust. But a string of other emerging economies, from South Korea to Ukraine, now appear to be on the brink of crisis.

Even in Western Europe, the financial fall-out is far from over. Almost every day, another powerful symbol of the sector's prowess bites the dust. Switzerland is almost as well known for its smooth, secretive bankers as for Toblerones, but last Wednesday acting finance minister Eveline Widmer-Schlumpf was forced to announce that she would rescue its biggest bank, UBS.

Berne will spend $54bn buying toxic assets from UBS. Widmer-Schlumpf was so busy dealing with the crisis that she opted not to fly to Washington for the IMF meeting last week. She is standing in for her colleague, Hans-Rudolf Merz, who suffered a heart attack last month.

UBS's rival, Credit Suisse, has managed to avoid holding out the begging bowl to taxpayers only by raising $8.75bn on its own, much of it from the Qatari Investment Authority.

Turning to cash-rich Middle East states such as Qatar is one solution more Western governments may have to take in the coming months. Another unpalatable but increasingly plausible-looking solution to the crisis is to ramp up public spending - unthinkable until recently, particularly in the UK, but perhaps the lesser of the evils if a serious recession is looming.

As the downturn bites, Kevin Gaynor of RBS says the bank rescue package only tackles one element of what he calls a 'three-legged stool'. Credit is becoming more expensive and harder to come by, which is the problem policy-makers were trying to tackle by propping up crisis-hit banks. But this process is being driven in turn by falling asset prices; which are being driven by declining incomes, among both consumers and firms.

Gaynor believes governments will only stop the rot by adopting a 'significant and sustained growth stimulus package' in the US and Europe: spending billions of dollars on infrastructure projects to create jobs and soak up some of the many thousands made unemployed. Already, politicians once firmly wedded to the power of the free market have adopted radical state-funded solutions. But economists are increasingly coming round to the idea that governments will have to throw a lot more money at this crisis before it is over.
The damage: experts' views

'By restricting flows of credit to households, businesses, and state and local governments, the turmoil in financial markets and the funding pressures on financial firms pose a significant threat to economic growth.'

Ben Bernanke, chairman, US Federal Reserve

'Once concerted government action is taken, the effects will take time and it is clear that there will be tough economic times ahead. Under any realistic plan, the re-establishment of trust, and more formally the decline in risk between financial institutions, will take time and patience.'

Olivier Blanchard, chief economist, International Monetary Fund

'Confidence is everything to business. If that evaporates, firms will not invest in plant, machinery or buildings.'

David Frost, director-general, British Chambers of Commerce

'Wealth declines in housing and equities will smother consumer and business spending.'

Scott Anderson, chief economist, Wells Fargo & Co

'A rapid rise in unemployment and worsening corporate profits.'

Peter Kretzmer, senior economist, Bank of America

'The dangers are falling employment, lower house prices and weaker consumer spending. The upshot is interest rates must come down considerably.'

Roger Bootle, Capital Economics

'It's important to distinguish between bank rate and interest rates in the economy, such as mortgage rates, because they are no longer moving together.'

Karen Ward, economist, HSBC

'The bank shares governments are buying at these depressed prices will almost certainly prove to be a bargain.'

Andrew Graham, Master, Balliol College, Oxford

'The credit crunch has created a human crisis in many of the poorest countries. The number of malnourished people is expected to rise by 44 million, to 967 million, as a result of high food prices.'

Robert Zoellick, president, World Bank

'All my clients are talking about it; there is a sense of a depressed mood, of uncertainty, a noticeable amount of anxiety and loss.'

Kit S Ng, Centre for Psychology in Singapore

Richard Wachman
Market psychology: when panic takes precedence

Fear has gripped financial markets, with share prices recording their sharpest falls since the Great Depression. But at times the wild gyrations of leading indices have defied logic. Why, for instance, have shares sometimes rallied strongly without any apparent explanation?

One theory is that the development of a large number of financial instruments enables investors to 'short' stocks in a bigger way than in previous bear markets.

As stock-market historian David Schwartz says: 'When large short positions have built up, as they have today, a major buying opportunity can emerge at the same time.' That sounds obtuse, so how does it work?

First, punters short the shares of companies where they believe the price will fall. The process involves borrowing shares from a financial institution such as a bank, which charges a fee, then selling them straight away in the hope of buying them back at a later date for a lower price when the time comes to return them. The short seller pockets the difference between the sale price and the purchase price. It offers the opportunity of making a large profit.

But what if shares go up? When that happens, or there is a belief that it might, short sellers rush to cover their positions by buying back shares at once in a desperate bid to avoid losses.

The accompanying buying frenzy pushes prices higher than they would probably go otherwise, tempting other investors back into the market. That partly explains the rallies that have punctuated the gloom of recent weeks.

But when you consider the much broader market falls, investors are not behaving that irrationally given that banks, housing and commercial property all hit the skids. For institutions that have 'gone long' - that is, held on to shares in the belief that things might get better - the past few weeks have been terrifying.

When the US bail-out package was initially blocked by Congress at the end of last month, it caught everyone unawares and led to a sharp decline in the value of shares. At times like that, the herd mentality kicks in.

Markets are forward indicators of what investors believe is in store in the next year or two. Recent worries have revolved around a possible collapse of the entire Western banking system; that now seems less likely, but the sell-off has continued because of the fear that, despite government intervention, a deep global recession looms.

Don't be surprised, however, if there is another big rally at some point in 2009, or even earlier. If investors believe recovery is within sight, shares could rise at exactly the same time as tens of thousands of workers are being laid off and businesses are going bust. Markets and economic reality do not always work in sync.

Richard Wachman