The credit crunch that began in the summer of 2007 has entered what might be seen as a second, more painful but also more productive phase. Crunch 1 saw a sudden earthquake rupture years of complacent calm. Crunch 2, however, began with the fall of financial institutions in markets that have lived in near-terror ever since Crunch 1.
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The financial sector, undermined by its excessive size and greed, is now shrinking, testing the ability of governments to manage the process and prevent systemic collapse. Such changes should be salutary in the long run, since finance has thrived excessively. Its creative excesses, profiting from overly loose monetary policies, have helped destabilize the global economy. But the shrinkage of finance and rebalancing of the economy will involve a marked slowdown of the global economy which brings risks of its own.
The slowdown will be sharp and may be prolonged. It is spreading around the globe from its epicentre, the US and the finance industry. But as the cries of exploitation by Wall Street ring out and the US government comes expensively to the rescue, what ought not to be forgotten is that the US consumer enjoyed being exploited.
Ordinary Americans lived well on the ultra-low interest rates of former Fed chairman, Alan Greenspan and on Wall Street’s self-interested largesse. From 2003 to 2006 US households realized gains worth $5.3 trillion (around Rs258.1 trillion) from the gain in real estate prices and a further $1.3 trillion from rising stocks and mutual funds. These figures are enormous, and might usefully be compared with the $700 billion now proposed as a rescue for banks.
Bearing the brunt: A file photo of potential buyers looking at a house in Westbury, New York, during a bus tour of foreclosed homes. US consumers’ disposable income is estimated to have been enhanced by about 5% annually from 2003 to 2006 by equity extraction from their homes. Jin Lee / Bloomberg
As Americans felt much better off—largely because of irresponsibly stoked inflation in house prices—they spent more. US consumers’ disposable income is estimated to have been enhanced by about 5% annually from 2003 to 2006 by equity extraction from their homes. But now the days of the home as cash machine are gone. Worse, the wealth effect Americans enjoyed is being replaced by a negative wealth effect, as the value of homes, equities and mutual funds falls. A similar blow befell Americans in 2001, when the stock market bubble of the late 1990s ended badly. Then Greenspan, real estate and Wall Street came to the rescue, inflating a new bubble.
But now, even with a 2% Fed funds rate, fiscal rebates and allocation of $700 billion from the government to Wall Street, there would seem to be no asset that can readily be inflated. At last the time to pay has come.
What this means is that the remarkable resilience of the American consumer looks set finally to be broken. For the first time since 1991, US consumer spending may visit negative territory, at least for a quarter or two. That will be part of the rebalancing of the US and global economy. In 2007, the US deficit on current account, the broadest measure of trade, was $731 billion, or 5.3% of gross domestic product (GDP). The weak dollar is making a contribution to reducing that deficit but weak consumption will bring it down further, reducing America’s need for external capital.
That, like the shrinkage of the financial sector, will ultimately be salutary for the US economy and the global one. Yet the world rightly fears the cure, whose first austere effects have been felt in the slowdown in European, Japanese and Chinese exports. In the eurozone and Japan—though not yet, much, in China—growth has slowed markedly and recession may soon be declared.
It is clear that in 2009 the world economy will be weak and unemployment will rise. That in turn will further threaten the financial sector. More debt is going to go bad and governments will continue to be faced with a need to ensure that the retreat of the financial sector is orderly, not a collapse.
It is apparent, too, that the ultimate costs of the new millennium property bubble are going to be felt for decades to come. The US government may well end up adding about $1 trillion, roughly 7% of GDP, to its debt. Governments in other countries—the UK, notably—will also add significantly to the burden taxpayers must bear for years, thanks to a foolish house party.
But how deep and how long the coming slowdown will be is unclear. Much will depend on the fate of the country whose cheap exports kept the consumers’ toys coming and whose savings, ploughed into half a trillion dollars of US treasury bonds, funded the spending: China.
China’s own stock market and real estate market have plummeted this year, yet its economic growth remains close to 10%. The focus of that growth must now shift, away from exports towards spending by the Chinese consumer.
The Chinese authorities realize this. The day after Lehman Brothers Holdings Inc. fell, the People’s Bank of China cut its interest rate and relaxed lending restrictions. If China keeps growing fast, global growth will be supported and a rebalanced world economy, buoyed, too, by interest rate reductions in major economies, may be bouncing back early in 2010. But if China’s growth falters, the credit crunch will produce another sequel. Crunch 3 would find our traumatized survivors battling prolonged and deep global recession. No one would want to see it.