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An observation on the credit crunch.. one year on

Evan Davis | 06:06 UK time, Saturday, 9 August 2008

It's not normally the case that when a country suffers a hurricane, it soon endures an earthquake. Hurricanes and earthquakes are uncorrelated.

But the main lesson to draw form the events of the last year is that in the economy, when the hurricane strikes the earthquake is not far behind. When things go wrong, everything goes wrong at once.

It's worth having an understanding of this variant of Murphy's law because in general, when life is stable we are good at imagining all sorts of things that can turn sour. But what we are not good at preparing for, is everything turning sour in one go.

I suspect the reason that bad news comes in waves is that economic systems are far more integrated than most of us realise. You change one piece of the machine (turn house price rises to house price falls, for example) and more things are affected than you could have imagined.

And in the economy, because so many different variables are upheld largely by confidence or sentiment, a knock to confidence in one area can easily be the trigger for a knock in confidence somewhere else as well.. (for example, sub-prime disasters in the US damage confidence in the reliability of UK banks .. so no-one lends to them for non-sub-prime mortgages).

Disasters that are correlated with each other are far worse than those that are not - they imply that you don't go from one stable situation to some small perturbation away from stability.

No. You go from one kind of stability to a new, very different stability a long way from the first.

This kind of jump defies the risk modelling that most clever institutions engage in.

This is an interesting issue in a year that has seen a lot of broad economic assumptions change. Just to name four "paradigms lost" since the credit crunch took hold:

the confidence of the financial sector has taken a knock, and with it the presumption that the future of our economy lies in expanding the city ever further

the reliance on consumer spending in the UK (and US) is no longer seen as being able to carry on sustaining the economy - saving is cool again

the unipolar economic world order, centred around the United States, has been significantly diluted as Asia strengthens in relative terms, and the US even depends on exports to Asia to cushion its slowdown.

the idea that raw materials can permanently be cheap has been challenged - commodity price hikes have alerted the world to possible shortages

Is it coincidence that you can say the last year has been significant in all four of these different respects?

Of course not. In many respects, at least the first three of the four are really simple re-expressions of each other.. the same formula that allowed banks to make money, encouraged consumers to borrow and allowed the resultant spending which made the US uni-polar global economy look strong. Un-do the formula and it's not just one thing that changes, but everything.

The harder one to explain of course is the rise in prices in commodities - this is the one that few of us predicted and which defies the usual logic that when the global economy slows down, raw material prices fall.

But we should have been prepared for everything to turn bad at once. In this case the low inflation conditions bestowed upon us by China's cheap exports in the early years of this decade, also led to the inflationary over-stimulation of demand for oil and other commodities.

Next time, we should be ready for the fact that however sure we are of ourselves, however strong the economy: after the earthquake, get ready for the hurricane.

Comments

  • Comment number 1.

    Evan,

    Implied in your piece above is that house prices rises are in some way 'good'. Will you please explain why you believe that inflation in house prices is a good thing under any circumstances?

    Then you remark on your lack of comprehension of the rise in commodity prices. The credit crunch was created by excess money supply being created through the construction of synthetic financial instruments (CDOs etc.) This money is still sloshing around the markets and is in the hand of speculators. Speculators do what they do speculate - hence the huge rise in commodity prices. The fact is that the World's economy has not yet reduced its consumption of commodities as the result of the increase in price as the adjustment is somewhat inelastic (once you have a gas guzzler you take time to swap it for a more efficient vehicle etc.)

    You are however quite correct in my view about the imported deflation caused by the expansion of Chinese manufacture and the lack of an associated rise in the Yuan. Our inflation statistics have been 'fiddled' by the agents of the Treasury in full knowledge of what they are doing. Leaving out the cost of housing and adjusting the make up of the index so that it looks good. This in turn 'forced' the Band of England to keep interest rates too low for a decade or so, devalued savings at the expense of borrowing and amplified the credit crunch.

    No matter how many times reasoned economic studies were presented (by me and many others) to the Bank and the Treasury they fell of deaf ears for political reasons and led to the artificial Brown boom the bust of which is just starting.

    You are right to note that there should be a large fall in commodity prices before the present bust reaches bottom and then (perhaps) a decade long recovery.

    The kiddies in the City will all be long gone before the next bunch make the same mistakes again! The Yuan will need to rise from the 15 or so that it is today to 2 to 4 before Europe's (and the UK's) manufacturing industry can be competitive and that will take a decade or more.

    One this that we must learn is that we cannot live on the Financial Services Industry alone- we must make things too!

  • Comment number 2.

    Evan

    Please can we resolve this time before we start thinking of the next time?

    I appreciate the `new' paradigm is now the old paradigm but we don't really know where we are at the moment to even conceptualise the future paradigm. I would even suggest that perhaps we would be better off without pardigms all together.

    John of Hendon raises an interesting point about the revaluation of the Yuan. I think that it is unlikely that a revalued Yuan will mean a return to productive employment in the UK and Europe on its own. There are other countries with burgeoning populations willing and able to take on production at low wages; Vietnam, Indonesia, and Malaysia immediately spring to mind. There are many others.

    What we need to find is a new industry whose technology we can develop and then sell on to others. Carbon cleaning technology and fuel technology are obvious choices for a start. We need a new USP other than financial services.

  • Comment number 3.

    Evan - A good way to create more space in Britain's prisons is to take the beds out and put straw down.

  • Comment number 4.

    A possible reason for the sudden increase of commodity prices while actual demand remains flat: people fleeing sub-prime mortgage investment and property speculation, as well as the ancillary economy that depends on these, need somewhere reliable to dump their money. What could be more reliable than something we can't do without, like food, and minerals?

    One thing we need to remember that may underpin everything for Western economies, is the fact that little of our economies is now dedicated to actual wealth creation, but more service industry and financial "skimming." Our economies are bound to be much less stable, with less actual wealth to underpin the money that is flying around.

  • Comment number 5.

    The Credit Cruch: Where has the money gone - follow the money trail? The crunch was caused by defaults on subprime mortgages in the USA and the fact that banks around the world bought some of this mortgage business from US banks. The US banks lent money to Americans who in turn used the money to buy houses from US building firms. They in turn bought land from US land owners and made profits for their owners. Am wrong or have banks in the US around the world just lost billions of dollars to private US land owners and building developers? Should there not be more comment about this and possibly a search for compensation.

  • Comment number 6.

    Evan

    I always assume that if someone has lost a lot of money then someone else has gained. If you're gambling and you lose - the House or the Bookie gets the money. With all these big big and massively wealthy banks going bust I assume someone else has their money. Who is the bookie?
    A bloke in my office who claims to understand economics says the money never existed in the first place and has basically evaporated. I suggested he was an idiot - am I correct?

  • Comment number 7.

    This comment was removed because the moderators found it broke the house rules. Explain.

  • Comment number 8.

    WHERE HAS ALL THE MONEY ACTUALLY GONE?

    In all the talk over the past few months no commentator, economist, banker or politician has actually explained where the billions now being replaced by governments have actually gone. Money just circulates around, doesn’t it? So how come billions seem to have disappeared into thin air?

    The answer is that it isn’t there because most of it never actually existed in the first place. People have forgotten that money is a measure of wealth created by human effort, not just abstract numbers in computer files. Bankers have made billions out of nothing. Here’s how.

    I take £1000 of my hard-earned cash to the bank and put it in my savings account. The bank lends it to someone to buy a house. The £1000 is passed three or four times from buyer to seller in the house chain until the last seller, who is not buying (perhaps they inherited the house from their parents who have died), takes the money and puts it in his savings account with the bank.

    The bank lends the same £1000 again to somebody else and the cycle repeats. The same £1000 repeatedly cycles through the economy without – and this is the crucial point – without anybody lifting a finger to create any wealth to enable it to legitimately enter its next cycle. In its second and subsequent cycles the money is not hard-earned; it is merely a number in a computer file and nothing more.

    So the £1000 has been lent repeatedly and if the system wobbles, such as one of the borrowers losing his job, my original £1000, which may have been lent ten times or maybe a hundred times, cannot possibly be repaid. In fact it is impossible to say where it is (but see below) because, of the total amount lent, only a fraction has ever actually existed. A wobble could also be caused by a general slowing of the economy or a decline in the savings rate in which people save less and want their money out of the bank.

    It should at least be obvious by this stage that the orphan and I cannot both get our £1000 back since there isn’t £2000 there.

    Each time the £1000 cycles round the bankers take a percentage even though no wealth has been created. If it goes round often enough they get it all, hence their billions of dollars in bonuses and my £1000 disappears into thin air. (It must be thin air since the Large Hadron Collider has not yet created any black holes.)

    Furthermore, each time the £1000 has been lent the borrower has promised to repay it from his earnings over the next twenty years. The money to repay cannot possibly be found now because the borrowers cannot suddenly put in 20 years of work instantly to create the wealth to earn the money to repay the loans.

    Contrast this with spending the money in the supermarket. Again the money repeatedly cycles round the economy but there is a difference. In this case the £1 you spend on a loaf of bread, for example, goes to pay the wages of the farmer, the baker, the driver who takes the bread to the supermarket, the oil worker who makes the diesel for the van and the checkout girl who puts it through the scanner. All these people have done useful work to the value of their wages and between them created £1’s worth of wealth to justify the £1 entering its next cycle through the economy.

    This example is simple, yet it explains why all the money seems to have disappeared into a black hole – sorry, thin air. Fancy “financial instruments” and practices like CDOs, leveraged this and that, hedge funds and short selling, which I don’t begin to understand, are doubtless clever devices which manage to turn money over even faster without creating a penny of wealth.

    It should have been obvious to the politicians that there was something wrong when bankers could pay themselves hundreds of billions – yes hundreds of billions – of dollars over the last decade in salaries and bonuses without doing anything more than moving numbers from one computer file to another. Why they didn’t realise or why they didn’t do anything about it is for them to explain. Over to you.

  • Comment number 9.

    BAIL OUT

    It has been reported that US Treasury Secretary Henry Paulson is worth about £700 million. Perhaps somebody should ask him how he managed to do $700 million worth of work in just 50 or 60 years.

    Presumably most of his money came fro his job at Goldman Sachs. He should ask 1000 of his friends to bail out the banks instead of the taxpayer having to do it.

  • Comment number 10.

    Be the first to see our latest viral video - a satirical look at the Credit Crunch featuring Bush and Brown:

    http://uk.youtube.com/watch?v=kQdNLFVdwfQ

    Sit back, relax and forget about the recession for a couple of minutes.

 

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