Four months after it exploded, the international credit crisis seems to be getting worse. On Monday the giant Swiss bank UBS announced losses of $10 billion.
Lawrence Summers, who served as treasury secretary under US president Bill Clinton, warned recently that “the odds now favour a US recession that slows growth significantly on a global basis.”
The problems facing the US and the world can be seen along several dimensions. The first is where the crisis started in the US subprime market, dealing in mortgages for people with poor credit records.
The US housing market is now in freefall. “We haven’t faced a downturn like this since the Depression,” one investment expert said recently. The current US treasury secretary, Hank Paulson, has drawn up a plan that would allow people with subprime mortgages they can’t repay to hold onto their homes.
Paulson isn’t acting out of benevolence. He’s worried that the big banks may be dragged down by the bad loans they end up with. Losses on US mortgage defaults are now projected to be between $150-300 billion.
Defaults on such a scale are likely to roll into people not being able to pay off their credit card bills, car loans, and the like. Bad loans could total $700-800 billion, a level comparable to the debt that paralysed the Japanese banking system for a decade after 1989.
But much of the international banking system is already paralysed. Since August banks have effectively stopped lending to each other – blocking a key mechanism of global finance. This reflects uncertainty about who is taking losses and how big these are.
So far banks have admitted to losses of about $70 billion. But, because the housing loans were sold on to other investors through fancy devices such as structured investment vehicles designed to make the banks’ balance sheets look good, the bad debts have spread throughout the international financial system.
“Grenades keep going off in the system and nobody quite knows what to think or expect,” a policymaker told the Financial Times. “There is a fear of the unknown.”
The paralysis is reinforced by fears about the “real economy”. The origins of the present crisis are to be found at the start of the millennium when the US Federal Reserve Board and other central banks reacted to the bursting of the dotcom bubble by flooding the world economy with cheap credit.
Consumers were encouraged to borrow more and keep spending. The danger is that this will now go into reverse. As credit becomes scarcer and more expensive, households cut back on their spending and hence the demand for goods and services falls.
So far this process is only at an early stage. Employment and production are still holding up in the US and Britain, the two big economies most directly affected by the crisis. But there are already signs that consumer spending is under pressure on both sides of the Atlantic.
Why don’t central banks just repeat their trick of six or seven years ago and slash interest rates? The problem is that the rate of inflation is rising. Last year it was above its target levels in the US, Britain, and the euro-zone.
Higher inflation is a reflection of the fact that the world economy has been growing relatively quickly in the past few years. Higher demand is pulling up the price of food, oil, and other natural resources.
This puts central banks in a very difficult position. If they give too big a stimulus to the economy this might cause inflation to accelerate to levels considerably higher than it has been for the past 15 years.
But if they don’t cut interest rates they – and the rest of us – could be faced with a world slump.
Reflecting this dilemma, last week the Bank of England cut interest rates by a cautious quarter percent while the European Central Bank left them where they were.
This timidity doesn’t begin to face up to the scale of the developing crisis.