The origins of today's market mayhem

Robert Peston
Economics editor

An investor monitors stock market prices in Kuala LumpurImage source, Reuters
Image caption,
Stock markets across the world have seen volatile trade in recent days

It is nearly four years since the day, 9 August 2007, which for many of us marks the start of the credit crunch - that in turn precipitated both the worst global banking crisis and recession for at least 70 years (see here for how I saw it on the day).

Banks and financial investors lost confidence that they could any longer value the trillions of dollars of financial products - asset backed securities, collateralised debt obligations - manufactured out of housing loans, especially poor-quality subprime housing loans.

So banks like Northern Rock and HBOS could no longer finance themselves by selling such financial products, which led directly to their respective collapses. And banks in general found it increasingly difficult to raise money, because of a generalised panic that their respective balance sheets were stuffed to the gunnels with near worthless assets.

When banks can't borrow, they can't lend. When businesses and households find it hard to borrow, an economic slowdown is the consequence. So over the subsequent nine months, credit crunch led to recession - which became acute in the autumn of 2008, when financial markets seized up altogether after the failure of Lehman (though all through the summer and early autumn of 2008, there was a steady erosion of confidence in the integrity of the financial system, especially after the collapse of the US state-backed housing-finance providers, Fannie Mae and Freddie Mac).

Today's financial crisis can be traced directly to those momentous events.

The response of governments around the world to the financial crisis and recession was to keep or even increase public spending, at a time of falling tax revenues, to compensate for the collapse of household consumption and private-sector investment.

Media caption,
Robert Peston: 'A crisis for the eurozone would be a very serious problem for the UK'

In other words, they ran abnormally high public sector deficits - peaking at deficits in the UK, US and parts of the eurozone at 10% or more of GDP - to prevent a global recession becoming a global depression.

In that sense, it is fair to argue that the recent increases in the public-sector indebtedness of many developed economies is the consequence in large part of the decisions taken in 2007 and 2008 not to let the banks and the financial system collapse.

Arguably the deleveraging of the banks, the shrinkage in their balance sheets, has been transferred to the state.

The overall volume of indebtedness in the economy is therefore still with us - although it has been shuffled from financial sector to public sector.

And if you took the view four years ago that the quantum of debt in the system was unsustainably large, then you would argue that by propping up the banks, the day of reckoning was being postponed, not cancelled.

Few would disagree that it is impossible for any government (or business or individual) to spend massively more than it is receiving in revenues for an indefinite period.

There is an argument - which we see being played out between government and opposition in the UK - about the appropriate speed for reducing that deficit.

But even America, which was last to sign up to any form of austerity, is on some kind of deficit-reduction track.

Which has spooked investors for two reasons.

There is evidence that economic recovery in the developed, rich West is anaemic and becoming weaker, and that the economic weakness, in the short term at least, is being reinforced by public-sector retrenchment.

But also, just like the awakening in 2007 to the idea that many of the housing loans and associated financial products were worthless, so there is a growing fear that a number of financially overstretched governments, especially in the eurozone, will not be able to repay their debts in full.

There has been an official recognition of that in the case of Greece, with the decision to encourage its creditors to swap their Greek loans for bonds worth 21% less.

And the concern of investors and creditors - as shown in RBS's results today (see my post of last night and see below) - is that Greece needs to reduce what it is prepared to return to lenders far more than 21%, to get itself back to some kind of financial health.

Which in turn has prompted many to look at what Ireland, Portugal, Spain and Italy owe, and conclude that they too may need to write down their debts.

The problem is that when there are concerns about the solvency of states, such as these, lenders to banks from those states also tend to become uneasy. Which is why Morgan Stanley, the investment bank, has been warning about the emergence of a new credit crunch for southern European banks - which in turn could infect and undermine the ability of northern European banks to borrow.

And, to say it again, when banks can't borrow, they can't lend. And when households and businesses have trouble borrowing, economic slowdown follows.

Or to put it another way, fears about solvency of sovereigns translates into potential liquidity problems for banks - which can then turn the solvency fears into self-fulfilling prophesies.

What's required, according to many analysts, is a circuit breaker in the transmission mechanism of fear.

The problem is that bankers' view of the supposed optimal size of the circuit breaker, in the form of an expanded eurozone rescue fund, the EFSF, is growing by the day.

A few weeks ago, an EFSF with 1tn euros to lend to overstretched eurozone governments, purchase government bonds and recapitalise banks might have been enough to reassure creditors and investors. Now bankers tell me it may need 4tn euros of firepower.

The problem is that a 4tn euros EFSF would foist an enormous potential liability on Germany. And the German people may not be ready to make that kind of financial commitment to their southern European neighbours.

Which, to state the obvious, is why we are living through such nerve-wracking times.

PS Like Lloyds, Royal Bank of Scotland's recovery from the crisis conditions of three years ago back to solid profitability has suffered a setback.

In the first half of 2010, Royal Bank of Scotland made a tiny profit. This year it has slumped back to a loss of £1.4bn at what is known as the attributable level. The pre tax loss was £794m.

The causes of RBS's woes are an £850m charge for compensating those missold PPI credit protection insurance, a £733m loss from writing down the value of what it is owed by the financially stretched Greek government, and a loss of more than £100m on the cancellation of a financial insurance contract related to Greek debt.

It is striking that RBS is taking a more pessimistic view of what the Greek will be able to repay than big French banks, BNP Paribas and Societe Generale.

Without those negative factors, RBS made an operating profit of £1.9bn, up from £1.1bn.

But there is still some way to go before its business as normal at RBS.

As for RBS's battered shares, they are 40% what British taxpayers paid for their 81% stake in the bank during the 2008 rescue. Which implies it will be years before taxpayers get their money back.