These look like dark days indeed. People in and around the financial markets are muttering about credit crunches, hidden losses and sub-prime meltdown. Wackier Wall Street commentators are calling it “Armageddon”.
Of course, anyone close to the markets is likely to be working for a hedge fund, investment bank or private-equity firm, all of which have had an extraordinary run of big profits in recent years on the back of the ultra-cheap money that has been slopping around the world. They are bound to get upset when the music stops.
So should ordinary people be worried about the turmoil sweeping the world’s credit markets? Are economies going to be damaged and jobs lost? Are we going to have to pay for the excesses of the financial markets? At the moment, there is little reason to worry. The world is no longer as reliant on the United States locomotive as it used to be, and that’s a good thing. It is also worth remembering what happened after the 1987 stock markets crash. World central banks busily cut interest rates to avert a meltdown. But there was no meltdown and the world economy boomed.
Right now the world economy has a lot of momentum. Sure, the housing market looks dreadful in the US with prices actually falling. But the economy is not in recession, unemployment is low and company profits remain at record levels.
So what do the events of last week tell us? Thursday and Friday looked alarming. The European Central Bank, US Federal Reserve and other central banks injected a total of $323billion of liquidity into the banking system to ensure there was enough cash for nervous investors to hold. That appeared to calm markets and brought down overnight lending rates. The Bank of England did not need to announce an injection of funds as it has a permanent facility for nervous banks to draw on.
The latest bout of uncertainty started on Thursday when French bank BNP Paribas said it had stopped withdrawals from three investment funds because of an “evaporation of liquidity”. Germany’s central bank, the Bundesbank, said it was organising a â,¬3,5billion bailout of German lender IKB, which had run into trouble lending into the US sub-prime mortgage market.
You expect European banking shares to fall if investors fear some of them may have got their fingers burnt in the US. This demonstrates the global nature of modern financial markets. Loans going wrong in the US are claiming casualties around the world, but the flip side of this is a positive thing. As Bank of England governor Mervyn King pointed out last week, it means better sharing of risk around the world.
These “collateralised debt obligations” and other credit derivatives help to spread risk more widely — and outside the banking system. That should make the world of finance more resilient to shocks such as the current crisis.
The turmoil was an accident waiting to happen. The Bank of England had warned about the growth of “leverage” (borrowing) and the “search for yield” for years and has been urging banks of all sizes to “stress test” their exposure to different financial instruments in case events like this should happen.
Calls have been growing for central banks, in particular the US Fed, to “do something” and they intensified towards the end of last week. That is usually code for cutting interest rates. Dealers have also grown used to the so-called “Greenspan Put” whereby the former Fed chief would cut interest rates at the first sign of market turbulence and bail out the financial sector.
His successor, Ben Bernanke, shows no such willingness. The Fed made it clear after its meeting last week that while the downside risks to growth had increased, it was still concerned about inflation — it wasn’t about to ride to the rescue.
If the feared “credit crunch” happens — where lenders get so nervous about extending credit that they stop lending — then that would be a problem. But we are far from that stage at the moment and firms around the world are sitting on plenty of cash, so they can still finance their own investment without resorting to banks. The banking system, too, is strong and profitable, so it is in good shape to withstand tremors as the pricing of risk by markets returns to more normal levels.
There are probably more banks with some loans that have turned bad, and the failure of a big bank could cause the sort of systemic failure that King mentioned. But for now, even if Porsche dealerships are worried, most of us outside the banking and market arena can sleep peacefully and watch the drama unfold. — Â