The Credit Crunch – reappraisal?

There has been a lot of comment on the state of the economy, the Credit crunch and the banking problems over the week-end. It is time to re-examine the views of this blog, and the responses from many of you.

I have argued:

1. The US and the UK will avoid recession but will experience a slow down, sharp in some areas and sectors. Some are trying to talk us into recession, by claiming the US is already in one, but the numbers tell us otherwise. It is quite clear that the Fed, the Treasury Secretary and the President will do everything they can to avoid recession in the US.
2. Inflation will remain unpleasant for the first part of 2007, but in a year or so will have reduced. Most of you disagree strongly, believing the current inflation will persist, and if the authorities do too much by way of cutting rates and making money available will trigger a faster one. I see no evidence that inflation is passing from energy and commodities into wages. We instead seem to be entering a period when real wages will be squeezed, limiting the second round inflationary effects.
3. The authorities need to do more to make the markets more liquid to ease the banking problems. So far the Fed has been very active, doing all it can. The Bank of England seems to be reluctantly coming round to the same conclusion. The ECB is half way there, making cash available but not cutting interest rates. Many of you dislike the advice I am giving, but the authorities seem to be moving in the direction I think is right.
4. The banks will gradually be recapitalised by rights issues, new share issues, and money from the cash rich parts of the world – Asia and the commodity producers. This is gradually happening.
5. UK house prices will fall, along with commercial UK property prices and US house prices. Some think UK residential property price falls unlikely because we are building so few new houses whilst new household formation is greater. I still stick to this view, because the mortgage market is tightening substantially. I accept there is no need for Florida style falls as we do not have the same over building problem and did not have the same degree of excess in sub prime mortgages.

Today Anatole Kaletsky has written one of his thoughtful pieces. He states that the banking crisis is a liquidity crisis, not a solvency crisis. A liquidity crisis is when banks need more cash to pay out depositors and other creditors than they have readily available, and find it difficult to sell their other assets quickly enough to raise the cash. A solvency crisis is when banks do not have enough total assets to meet all their liabilities, so they need to raise substantial new capital.

I agree with him that Northern Rock and Bear Stearns both were liquidity crises – depositors and creditors lost confidence in the institutions and demanded more cash than the institutions could immediately lay their hands on without official help.
The one thing we have to remember, however, that is not in his article, is that a liquidity crisis if badly handled by the banks and the authorities can become a solvency crisis. If Institution A is experiencing a run on its cash, it needs to sell assets quickly to raise more money. This, in poor markets, can drive the price of these assets down to unusually low levels. All banks then have to mark down the value of their assets on their balance sheets, as even high quality assets can no longer be sold for good prices in such conditions. This can lead to some institutions no longer having sufficient assets to cover all their liabilities, so they need to raise more capital or they get into trouble.

This is why some of us recommend that the authorities should help the markets by intervening to keep the price of high quality financial assets up to realistic levels. If the Central Banks stand by and watch as well run institutions are forced to sell high quality assets for well below their normal value, they are allowing more serious problems to emerge in the banking system as a whole. It is in everyone’s interest that high quality mortgage debt, high quality bonds and corporate debt should sell at realistic prices, related to the current structure of interest rates. In a liquidity crisis the price of good quality assets can be driven down too far, putting pressure on well run financial institutions.

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4 Comments

  1. Tony Makara
    Posted March 24, 2008 at 2:26 pm | Permalink

    John, do you feel that a decline in Sterling relative to the Euro will have an inflationary impact on high street prices? Would such a scenario be enough to put pressure on wages? If/when the Pound falls after such a long period of being overvalued, what policy should the MPC adopt? Should the MPC raise rates to support the currency to protect us from importing inflation?

    Reply:I THINK THE FALL OF THE POUND AGAINST THE EURO WILL MAKE US POORER BUT IS NOT NECESSARILY INFLATIONARY – WE WILL JUST BUY A SMALLER QUANTITY OF EURO DENOMINATED GOODS AND START PRODUCING MORE IMPORT SUBSTITUTES AT HOME. IT WOULD ONLY BE INFLATIONARY IF AT THE SAME TIME WE HAD A CREDIT EXPLOSION WHICH DOES NOT LOOK VERY LIKELY AT THE MOMENT.

  2. mikestallard
    Posted March 24, 2008 at 9:53 pm | Permalink

    What happened during the last Labour administration was that there were a lot of strikes and a subsequent inflationary wage race.
    Notice how the NUT have decided on one day strikes and a ballot. The Police weren't too pleased with their pay settlement either, I seem to remember.
    We all know on the ground down here away from Westminster that a 2.1% inflationary rate comes straight out of 1984 with the endless self congratulatory figures constantly repeated over the radio.
    Meanwhile, the government is taxing alcohol and is about the put up Council Tax. This will cause inflation too, won't it?
    At a deeper level, I want to ask, "What is England for?" In the 19th century we were the manufacturer for the whole world. Today that has, surely, fallen to China? I cannot see, myself, what our wealth is actually based on. Can you?

    Reply: THE MAIN SUCCESS ECONOMICALLY IN RECENT YEARS HAS BEEN FINANCIAL AND BUSINESS SERVICES – LONDON, ENGLAND HAS BECOME OF OF THE KEY BUSINESS SERVICE CENTRES OF THE WORLD. WE ALSO STILL HAVE SOME GOOD MANUFACTURING, WITH SOME GOOD OFTEN FOREIGN OWNED COMPANIES IN PHARMACEUTICALS, AUTOS, AND AEROSPACE ENGINEERING FOR EXAMPLE.

  3. tim holden
    Posted March 28, 2008 at 4:36 pm | Permalink

    Amongst the larger lies developed by the previous Chancellor is the one that Britain is no longer about boom and bust. There has been a lengthy boom funded by a surplus of credit, which was provided by banks that have profited well.

  4. tim holden
    Posted March 28, 2008 at 4:56 pm | Permalink

    …. sorry that went thru before I had finished.

    A craven FSA turned a blind eye to the process beyond the point of embarassment, and the Northern Rock fiasco signalled the boom's definitive conclusion.

    Spirals of credit are likely to unravel into a bust of lengthy duration. The extreme reluctance of banks to lend to each other is a clear signal of their individual losses – and their surmise that their fellows have also suffered. And if they are short of funds, then it is difficult or them to lend.

    Britain may be in a uniquely difficult position – the very opposite of what the dreadful duo of the new PM and the new Chancellor claim. Their optimism almost certainly stems from a mixture of ignorance and the failure to comprehend that their long lucky streak has come to an end.

    The switch of manufacturing from Britain to China has kept inflation down. The certainty of Chinese inflation will have the ongoing effect of sharp inflation here. A stronger currency would diminish the effect of higher Chinese prices, but that can only be maintained by holding interest rates high – and high interest rates will adversely affect the local housing market.

    It is going to be more than interesting to observe how this doomed pair seek to avoid blame. The first casualty will be the Chancellor because it would be a popular move to get rid of him – despite the excrutiating prospect of Ed Balls replacing Alistair Darling. But the PM is trapped in the searchlight, uncomprehending of the extent of his unpopularity. We do not deserve the bust that he has brought upon us – but there will be some compensation that the exit-stage-left will be of a permanent nature.

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, He graduated from Magdalen College Oxford, has a DPhil and is a fellow of All Souls College. A businessman by background, he has been a director of NM Rothschild merchant bank and chairman of a quoted industrial PLC.

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