27 February 2009

No chance of a return to the dark days of the 30s? Don't kid yourself

Nice work if you can get it. The Royal Bank of Scotland has clocked up the biggest corporate loss in UK history and the bloke at the helm when the ship went down trousers a pension worth £650,000 a year. Understandably, there is concern that Sir Fred Goodwin should have no money worries for the rest of his life, but ministers have only themselves to blame. They could have sacked him last October and saved themselves a tidy sum. As it is, the furore over Goodwin's pension has helped to disguise the fact that the taxpayer is now underwriting the biggest insurance policy in UK history in the hope that indemnifying RBS against future losses will get the bank lending again.

Public fury at Goodwin and the other failed bank chiefs is inevitable, but a diversion from the big issue: that policymakers are rapidly running out of road in their attempts to pull the global economy out of its nosedive. There is little agreement on what marks the difference between a recession and a depression, but the one put forward by Stephen Lewis of Monument Securities is as good as any. A recession is where policy works; a depression is where it doesn't.

Judged in this way, there is scant cause for optimism. America is in a terrible state: factory output has nosedived, unemployment is going up by more than half a million a month and consumer confidence has collapsed. Courtesy of globalisation, the acute weakness in the world's biggest economy has had a domino effect on Japan, China, Germany, eastern Europe and every other corner of the planet.

Here in Britain, the picture is a bit more mixed. The Nationwide building society has reported that house prices continue to plummet and are now down more than 20% from their peak, but the never-say-die spirit of the British consumer has meant that the latest news from the high street has been less bad than expected. Let's be clear, though: the situation is now grave. Long gone are the days when policymakers assured us that this would all quickly blow over or that decoupling would ensure that the emerging markets could act as the locomotive of the global economy.

Alistair Darling hopes that the rapid retrenchment in the global economy will lead to an equally rapid recovery, but there is no guarantee that this will happen. To be sure, everything and the kitchen sink has been thrown at the problem; interest rates have been cut, fiscal policy has been eased and there is now talk of cranking up the printing presses to boost the money supply. This is a heady cocktail and eventually the expansionary policies will work. The key word, though, is "eventually". A credit bubble of unprecedented proportions is deflating and in those circumstances it is nigh-on impossible to predict a turning point. Darling may well prove right in his prediction of a V-shaped recession but you would be mad to bet the farm on it. For one thing, badgering the banks to increase the supply of credit without increasing the demand for credit is a half-baked solution to an economic crisis. If consumers are losing their jobs, or are worried about losing their jobs, they are not going to be taking on more debt. As Nick Parsons, analyst at NAB Capital, put it: "The conversation over the breakfast Coco Pops is hardly going to be 'Oh, I see the asset protection scheme has now been introduced, shall we go and buy a new car on Saturday dear and have a look at a bigger house?' "

It is also a concern that policymakers continue to attack the symptoms of the problem rather than the cause. Banks in the US, the UK and elsewhere will remain on life support until a floor is put under house prices, because losses in real estate feed through into losses for the banks and an increase in toxic waste. In those circumstances, bail-out will follow bail-out until the tidal wave of foreclosures is stemmed. Danny Gabay, of Fathom Consulting, says the UK government should use a £50bn slug of the money it intends to print on buying up homes at threat of repossession for a discount and allowing their owners to rent them back.

This is a drop in the ocean compared with the sums that have been spent on propping up the banks, but there would be a risk of re-inflating the bubble that caused all the problems in the first place. We may look back next year and ask why nobody warned that cheap money, tax cuts, bank guarantees and public spending increases would lead to a sudden burst in inflation. It is quite conceivable, for example, that the price of oil will shoot back up towards $100 a barrel if and when real green shoots start to appear.

Sadly, however, there are no longer any risk-free options. Policymakers are preoccupied by the need to avoid debt deflation and depression, but they have never been in control of this crisis and are now making it up as they go along. There is a reluctance to let banks fail but also a reluctance to nationalise them. State ownership could make sense even if the aim is to return the institutions to the private sector as quickly as possible, since governments can use the state balance sheet to recapitalise the banks at a cheap rate; but ideology, both here and in the US, has trumped common sense. Barack Obama may be getting top marks for his oratory, but the performance of his new treasury secretary, Tim Geithner, has thus far been undistinguished. The plan to revive the banking system is sketchy, and bears all the hallmarks of being made up on the hoof.

The Federal Reserve, for its part, floated the idea late last year of using quantitative easing but has now gone cold on the idea. This looks like a serious error, and one that threatens to blunt the impact of the much-vaunted stimulus package. Until the slide in prices that began in 2006, there had never been a single year since the second world war in which US house prices had fallen. The latest figures show that in the major cities they are now down by more than a quarter since the peak. The real purpose of quantitative easing is to bring down long-term interest rates, which affect the cost of a hefty proportion of American mortgages. Although the cost of borrowing has come down over the past few months, it has fallen by far less than during the much less severe downturn of the early 1990s.

The reason we are supposed to be cheerful is that bad as things are, at least will be no repetition of the 1930s, when egregious policy errors led to slump, protectionism and extremism. This prediction, like all the others blithely made since August 2007, looks highly suspect. Look around the world and what do you see? You see signs of deep economic distress and policy mistakes. You see emerging markets being starved of capital, because the big western economies are looking after their own domestic constituencies. And you see the first stirrings of real public anger at the way in which those responsible for the biggest economic catastrophe since the second world war appear to be getting away scot-free. No chance of a return to the 1930s? Don't kid yourself.


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