Tuesday, 25 November 2008

This slump will overwhelm Brown

Graham Turner

The tax cuts unveiled by chancellor Alistair Darling on Monday were cheered by the Labour Party faithful. But one only has to cast a glance at the recent shocking turn of events in the US to see why these tax cuts will fail to rescue the economy.

The US Federal Reserve has slashed interest rates to around 0.5 percent. It can hardly go any lower. Yet the slide in the US housing market shows every sign of accelerating. Banks are losing so much money that they will not cut the cost of mortgages.

The most prescient indicator for the US housing market is a monthly survey by the National Association of Home Builders. Its November report shows housing demand falling faster than ever.

The weekly report from the Mortgage Bankers Association, another US organisation, reinforces the point. It shows that demand for mortgage loans has also tumbled since last month's stock market collapse.

The October crash on Wall Street was a belated response to downturn in the US housing market that started three years ago. But now the slide in share prices has in turn undermined confidence in the housing market.

It's a vicious circle that the Federal Reserve seems powerless to stop it. And it means that the losses on mortgage-backed bonds — losses that precipitated the failure of Bear Stearns and Lehman Brothers — are now multiplying.

These losses have now come close to bringing down Citigroup, one of the US's largest retail banking groups. The US administration had to step in with a $300 billion bailout to save it.

The biggest falls in these mortgage bonds are now being seen in the “triple A” sector of the market—supposedly the safest possible form of debt. This crisis has moved far beyond its roots in the subprime mortgage market and is migrating up the chain.

As unemployment rises, more homeowners are falling behind on their mortgage payments. Repossessions are already running at over three times the peak of the last housing recession in the early 1990s.

Corporate borrowing costs have also soared. Many companies are unable to borrow except at penal rates. This is making it difficult for them refinance their already onerous debt burdens.

General Motors now has to pay interest rates of over 50 percent to refinance existing loans and may soon collapse. One of the most vital cogs in the capital markets has utterly broken down.

Ben Bernanke, the hopelessly inadequate chief of the Federal Reserve, claimed last week that the liquidity crisis had eased. And the Libor rate — the rate that banks lend to each other at — has indeed fallen.

The problem is that ordinary companies cannot borrow at Libor rates. Many of them finance their balance sheets through the corporate bond market. And the collapse in stocks and mortgage bonds means that investors are too frightened to lend.

That is why corporate bond yields — which measure the borrowing costs for corporations—have risen. And as existing loans come up for renewal, companies will default—unless they can somehow slash costs.

That means job losses. And we should now be very worried. Monthly job losses in the US may reach 700,000 next year. That compares with to a September loss of 240,000. The current post-war record monthly loss is 602,000 jobs, set in December 1974.

The US unemployment rate could surpass the 1982 high of 10.8 percent by the end of next year. And it will carry on climbing, possibly reaching 15 percent or more by 2010.

The resulting social upheaval will pose a grave challenge for Barack Obama's incoming administration. But the paucity of his economic strategy should concern us too.

Obama's current plan is heavily influenced by Lawrence Summers, the former US treasury secretary. It amounts to little more than a rehash of the post-war "Keynesian" consensus that failed to resuscitate Japan's economy in the 1990s.

Increases in public spending or tax giveaways will not solve the core problem, which is how to stop borrowers from defaulting.

In 1932 the Federal Reserve drove interest rates down aggressively, which helped turn the tide. Corporate borrowing costs fell. It was still
not enough — but it was more proactive than the botched policies of today.

By the time the Obama camp realises the error of its ways, even the more radical policies of the 1930s may well be insufficient. Interest rate controls, unparalleled intervention and a state of emergency may eventually be the belated response to stem the slide into depression.

A deep and prolonged contraction in the US will hurt the rest of the world. Britain's top heavy financial sector will be hit even harder. The FTSE 100 stock index may slump to levels not seen since the early 1990s, tumbling 2,000 points.

Financial institutions will be forced to shed even more workers. The impact on consumer demand will be immense, leading to more layoffs across the manufacturing and service sectors. And that will utterly overwhelm the short term benefits of this week's tax cuts.

Graham Turner, Author of "The Credit Crunch", published by Pluto Press and available from Bookmarks for £12.99


  1. What effect do you think the slump in raw materials prices will have?

  2. The slump in raw material prices is a result of the decline in demand.