Deep pessimism sweeping through the financial markets has threatened to
become a vicious circle. In contrast to earlier complacency, G7 governments have
adopted unprecedented measures to stop their banking systems from collapsing.
As well as buying toxic assets on a colossal scale and effectively
nationalising major commercial banks, the G7 has flooded money markets with
liquidity and cut interest rates aggressively. But recurring failures have
engendered a mood of despair. If even mighty governments fail to restore
confidence, the consequences could be catastrophic.
When exploring the credit crisis six months ago, I identified four potential
• Calamitous 1930s-type financial meltdown, involving slump and massive
• Japanese 1990s-type prolonged stagnation;
• Inflationary upsurge, resulting from over-aggressive fiscal and monetary
• US dollar collapse, US default and loss of US creditworthiness and global
There were worrying signals last spring that the situation was worsening, but
extreme scenarios appeared remote. The most likely outcome at that time was
relatively benign: 12-18 months of below-trend growth; a mild US recession; and
slow improvement starting around mid-2009. This view still seemed realistic
until the Lehman Brothers collapse and the effective nationalisation of Fannie
Mae and Freddie Mac this September.
Where are we now? We have moved dangerously towards scenarios 1 and 2. A
banking sector meltdown, though so far averted, remains a real possibility.
Banking threats could re-emerge and in the real economy, the recession is
serious, rather than mild. The downturn is not confined to the US. Prospects for
Europe and Japan are at least as poor.
Output falls and unemployment increases will be significant in all the major
economies. Even after outright recession ends, stagnation and lost growth will
persist for much longer than previously envisaged. Bank balance sheets remain
burdened with huge bad debts.
Government persuasion or coercion may not be able to unblock banking sector
paralysis, and ensure a normal flow of finance. Indeed, sound businesses may be
reluctant to borrow and invest in the face of serious recession.
The inflationary upsurge in scenario 3 appears unthinkable in the next
one-to-two years, but is a very realistic danger in the longer-term. Recession
and plummeting commodity prices will reduce 2009 inflation and may even cause
deflation. But over-aggressive fiscal and monetary policy, aimed at alleviating
recession pains, will unleash powerful inflationary pressures in the future.
Since the credit crisis originated in the US sub-prime market, and the US
economy is badly hit by big job losses and sharp house price falls, many have
predicted dollar collapse and loss of US status envisaged in scenario 4.
However, the sharp recovery in the US dollar has been a remarkable consequence
of the crisis. The longer-term US global status remains uncertain.
There are sound reasons for perceiving the US as the safest and most
attractive haven for international capital amongst the G7. The US is still much
more powerful than Europe and Japan. The recession will be shorter in the US
than in other G7 countries. Global economic power may move towards China, India
and other emerging nations. But the US will remain dominant among the G7.
It is difficult to be optimistic, but excessive pessimism is unjustified. The
recession will be nasty, but we will probably avoid a major depression.
Governments have taken essential steps to address the most urgent priority
avoiding a banking sector collapse. Higher unemployment and business failures
are unavoidable. But governments cannot afford to lose the battle over restoring
banking stability. If recent measures prove insufficient, more will have to be
The short-term economic cost of resolving the banking crisis, though high, will
not be devastating. But the longer-term political fallout may cause serious
damage and result in poorer, less efficient and more regulated societies. In a
febrile political environment, many factors are being blamed for the crisis:
excessive accumulation of debt; unduly lax US monetary policies; exaggerated
booms in house prices; the opaqueness of the “originate and distribute” banking
model; and a flawed banking reward structure encouraging greed, disproportionate
risk-taking and speculation. The severity of the crisis has prompted strident
calls to punish the guilty perpetrators and change the system.
Consequently, there are now attacks against globalisation, free trade and
capitalism. Yielding to these assaults will cause immense damage. There is also
dangerous clamour for draconian financial regulation. But the banks will have to
accept radical reforms.
The least harmful way forward is to separate more tightly between two
elements: 1) vital utility banking (i.e. running the payment system and
providing finance to individuals and small businesses) that cannot be allowed to
fail and must, therefore, accept greater regulation; and 2) more speculative
investment banking that can be allowed greater freedom, but where failure will
not endanger the whole economy.