Commentariat

Times Anatole Kaletsky

The British economy’s 16-year period of uninterrupted growth officially ended
with the announcement on Friday that second-quarter gross domestic product
showed zero growth, rather than the previously estimated 0.2 per cent. Does
this really matter to anyone but statisticians or devotees of Guinness World
Records? The answer depends on whether this slowdown turns out to be a
hiccup or the start to a prolonged period of zero or negative growth. In the
former case, the temporary slowdown will soon be forgotten - or will be
remembered merely as the statistical by-product of a correction in house
prices that was inevitable and overdue.

A theme of this column for almost a year has been the contrast between
apocalyptic views in the financial markets about the earth-shattering
consequences of the credit crunch and the rather more mundane evidence from
the real economy of a mild recession, at worst. My view has been - and
remains - that this episode is likely to be remembered as one of those
extremes of panic or euphoria in financial markets, which tend to reoccur
once or twice every decade, when market prices - of bank shares, of oil, of
the dollar and of several other assets - turn out to be simply wrong.

Sometimes the markets just get things wrong. It doesn’t happen very often.
Usually the market’s collective wisdom is more perceptive than the
individual opinions of the investors who comprise it. But every now and then
- about twice every decade - markets make spectacular blunders, completely
losing touch with the real economy of consumption, investment, employment
and world trade. The markets’ behaviour last week suggested that such a time
has arrived.

After the stock market’s worst half-year since the early 1990s, nobody - not
even I - can deny any longer that financial assets around the world are in a
severe bear market. But with so many of the world’s most important markets
last week retesting their post-credit crunch extremes - the FTSE at 5,500,
the S&P 500 at 1,280, oil at $140 and the euro at $1.60 - it seems worth
asking the defiant Churchillian question: Is this the end of the beginning
or the beginning of the end? Is the bear market only just starting and about
to break down to much lower levels? Or is it possible that last week was a
test of the lows hit by equities and the dollar in the credit crisis and the
high hit by oil two weeks ago?$

Why does anyone still think that the US economy is in recession? A week ago,
this belief acquired a host of new adherents when Jean-Claude Trichet, the
European Central Bank President, more or less promised to raise eurozone
interest rates on July 3, while US statisticians reported a jump in the
unemployment rate from 5 to 5.5 per cent. Financial markets duly bid up the
euro and dumped the dollar. This currency move triggered the biggest one-day
leap in oil prices on record. This price surge, in turn, confirmed that
recent movements in the oil price, which have had a 97percent daily
correlation with the dollar-euro exchange rate, have been driven almost
entirely by financial players and have had very little to do with energy
supply and demand.

Just as the credit crunch seems to be ending, the world faces a much more
serious economic threat: the explosion of oil prices and the possibility of
a return to 1970s-style inflation. Inflation is a more dangerous economic
ill than deflation because it is so much harder to cure. Falling prices can
be cured easily enough. All governments and central banks have to do is cut
interest rates, cut taxes and boost public spending. These are popular steps
that readily win political and business support.

Mervyn King’s announcement that “the Nice decade” is over was not quite what
it seemed. The Governor actually made the same forecast four years ago in an
interview with The Times, immediately after his first appointment to run the
Bank of England. His adjective “nice” was intended less as a value judgment
than a succinct statistical description of the past ten years or so. In
terms of economic figures, it is an undeniable fact that the 15 years since
Britain was expelled from the European exchange-rate mechanism has been an
unprecedented period of “Non-Inflationary Continuous Expansion”. Hence the
acronym “Nice”.

What went wrong? This week two of the most successful centre-left politicians of their generation are asking themselves this question as their dreams of glory collapse. While Hillary Clinton at least has the consolation of carrying on her political career as a respected and powerful senator, perhaps even as vice-president in a Democratic “dream ticket”, Gordon Brown can only look forward to two years of parliamentary humiliation, internecine backstabbing and lame-duck impotence, followed by electoral defeat. At the moment, however, the common features of these two defeated politicians are more interesting than the many differences between their plights.

So the sky did not fall in. While the Chicken Littles of the world economy,
led by Gordon Brown, George Soros and Warren Buffett, may still repeat
mechanically the IMF’s surprising judgment that the world - especially
America - faces its worst financial crisis since the 1930s, their hearts are
no longer in it. Mr Brown, after last week’s election woe, can no longer
blame the world economy for his political failure. Mr Buffett, having
speculated against the dollar for years and declared that credit derivatives
are financial weapons of mass destruction, has finally begun to find
attractive opportunities to invest his money and told his shareholders last
week that the worst of the credit crisis was probably over. Mr Soros, in his
forthcoming book, The New Paradigm for Financial Markets, states
unequivocally: “We are in the midst of a financial crisis the likes of which
has not been seen since the Great Depression.” But after making $3 billion
for Quantum Endowment Fund by anticipating last year$’s bear markets, he is
now hedging his bets, as is only to be expected from the world’s most
successful hedge fund manager. “I may well be proven wrong,” he told The New
York Times last week, adding that he might yet again turn out to be “the boy
who cried wolf”.

What Gordon Brown has described as the most serious financial crisis since the
1930s, appears to be over as suddenly as it began.

Now that the Bank of England has got off its high horse and decided to support
British banks in much the same way that the European Central Bank has been
supporting Spanish and German banks since last August, governments around
the world are finally committed to publicly funded financial workouts. This
is the “Plan B” that I have described here – the inevitable next stage in
the credit crunch, once it became apparent that a market-based solution was
doomed to fail. Now that Plan B has swung fully into action, global credit
conditions should gradually return to normal in the months ahead. The bad
news is that “normal” does not mean anything like the conditions that have
prevailed in the world financial system and the global economy during the
past few years.
Three lasting changes in the world economy are likely to result from the
credit crunch. First, the US economy, which should start to recover this
summer in response to fiscal and monetary stimulus, will no longer be
powered by housing and consumption, but mainly by exports and manufacturing.
Secondly, the British and European economies, which are 12 to 18 months
behind the US in a broadly similar monetary cycle, will only now begin to
experience an economic slowdown and housing slump as serious as the one that
has almost ended in the US. So, while the credit crunch may be in its final
stages globally, its economic impact will probably be far more noticeable
from now on in Britain and Europe than in the United States.
Thirdly, the emerging economies of Asia and other developing regions will no
longer enjoy export-led growth as consumption in America and Europe becomes
structurally weaker. If the developing countries are to continue growing
rapidly – and I believe that they will – they must rely on domestic
consumption, infrastructure investment and their own home-grown property
booms.
These three fundamental shifts in the world economy are by now widely
recognised. There is, however, another apparent consequence of the credit
crunch that is less understood and is causing consternation and anxiety,
especially in China and other developing countries. This is the upsurge in
oil, food and commodity prices, many of which have almost doubled since the
credit crunch began last August, even though the causal linkage between
soaring commodity prices and a collapsing supply of credit remains obscure.
If anything, the credit-induced slowdown in global economic growth and
consumption since last August should have weakened demand for commodities
and therefore pushed down prices. Yet the reality is that commodity prices
have recently leapt higher every time the global banking system was hit by
some new shock.
As a result, China and other emerging countries, which last year were
preparing to boost domestic consumption to compensate for weaker exports to
the US, are now more worried about inflation and are raising interest rates
to try to slow their domestic growth. This is potentially a very dangerous
development for the world economy, which increasingly relies on domestic
demand from Asia, the Middle East and Russia. This unexpected policy
tightening by emerging nations also explains why stock markets fell far
harder in Asia than in America and Europe in the first quarter of this year.
Why, then, has a global collapse in credit created a boom in commodity demand?
The short answer is that nobody knows. A common explanation in the media is
that soaring commodity prices reflect a global panic about inflation, as the
Federal Reserve Board supports the US banking system by printing money and
slashing interest rates.
This explanation does not pass muster for at least three reasons. First,
because US inflationary pressures are already subsiding as a result of the
credit crunch and the associated fall in house prices and employment.
Secondly, because the ECB and the Bank of England show no sign of imitating
the Fed’s expansionary monetary policies, yet commodity prices are soaring
in sterling and euros as well as dollars. Thirdly, because the commodities
rising fastest – such as rice, wheat and pork – cannot be used as long-term
stores of value and so must reflect the balance of supply and demand for
instant use, rather than fears about loose monetary policy and its possible
effects on inflation many years ahead.
What, then, has suddenly boosted demand for agricultural commodities and how
might this be related to the credit crunch? A possible explanation is that
the rise in prices itself has triggered a self-sustaining upward spiral of
demand, in which investors, wholesalers and final consumers want to buy more
of a commodity each time its price rises and this leads to more hoarding and
still higher prices. Such self-sustaining price trends are normally rapidly
reversed because value-oriented investors and commodity producers start to
trade against the trend, selling more each time the price rises. In present
conditions, however, it is harder than usual for speculators to trade
against the rising price trend, because bank lending has dried up. Several
American grain wholesalers, for example, have been pushed towards bankruptcy
because they have sold futures against grain supplies they bought in advance
from US farmers and have then been unable to finance these temporary “short
positions” until the next harvest comes along.
By draining liquidity in this way from all financial markets, the credit
crunch has exacerbated trend-following behaviour among investors, promoted
stockpiling throughout the global supply chain and encouraged hoarding by
consumers. This financially driven process, rather than a sudden increase in
Chinese and Indian appetites, has probably been the main cause of this
year’s shortfall in global food supplies.
Similar influences may explain other surprising linkages that have suddenly
emerged between financial markets. Since the credit crunch’s start,
commodity prices have developed an uncanny correlation with the euro/dollar
exchange rate (see chart) and this currency trend, in turn, has been
powerfully correlated to two other momentum-driven trends – the collapse in
US Treasury bond yields and the widening of credit spreads.
If all these trends are driven ultimately by lack of liquidity in global
financial markets, they are all likely to turn at about the same time, or in
a fairly tight sequence - and this process may now be starting. The trend in
credit spreads began to reverse in mid-March after the Bear Stearns rescue –
and last week, more or less on cue, the predominant direction of the US bond
market seemed to switch from lower to higher bond yields. If this rise in US
bond yields proves sustainable, the overwhelming currency momentum against
the dollar and in favour of the euro may also start to reverse. If that
reversal occurs, the trend in commodities should soon follow and the panic
about inflation in China and other emerging economies should start to
subside. At that point, we will finally be able to say that the worst of the
global credit crunch is over.