I’m sure you are all aware of the condition the world economy is in at present (ie. bleak). And so, I won’t talk about how all of it transpired, but I want to look at the various different effects that have been observed, and suggest possible ways of tackling the problems that they raise.

The ‘Credit Crunch’ and Lending

The financial sector has been at the heart of the downturn. In a nutshell, because confidence was high and people were happy to gleefully spend away without thinking of the consequences (the financial industry seem to be a bit short-sighted and not learn from previous mistakes), banks in the US began lending to people who were unlikely to be able to pay them back. You’d have thought by watching all those TV shows and cartoons where ‘get rich quick’ schemes backfire that some alarm bells would have started ringing at this point.

Apparently they didn’t. They financed lending by selling the debt to various different banks in such a way that they could absorb the interest they charged to their borrowers. This is how the loan market makes money anyway, but generally they make rigourous checks to make sure people can pay them back. So banks were strangely surprised when the people who were unlikely to pay them back… didn’t actually pay them back.

The main problem this has created is that lending has dropped – both in the form of loans & mortgages, and inter-bank lending, which happens daily on a large basis, and is what keeps the system working. This is because banks can now not afford not to get paid back, and know that the risk of default (not being able to pay back your loan) is much higher now.

And so governments have poured money into the sector to try to give banks enough spare cash to throw around. The US injected $700 billion, and the UK and EU countries have followed suit.

However, I’m sceptical. Suppose you worked for someone in an engineering job and your boss wanted you to buy some physics books so that you could educate yourself and make yourself more useful. So he gives you £100 to do so. I’d say it’s pretty likely that you’d spend the money on something nice for yourself and read some stuff on the internet instead.

The point is that banks don’t necessarily have to lend the money that they’ve been given if they don’t consider it to be worth their while. Having more money will definitely increase your confidence in terms of risk-taking, but it’s not a given.

Inflation and Monetary Policy

Injecting vast amounts of money has a nasty side effect – inflation (an increase in the average price level of goods and services in an economy). Usually, this is because confidence and spending increases overall – driving the price level upwards. At the moment though, that probably isn’t so much of an issue because of the fact that people and businesses are less confident due to a loss of wealth caused by slumps in the stock and housing markets.

Still, inflation has already been high. In the UK, the target of 2% has been more than doubled with 4-5% inflation for close to a year now. This became the case for 2 main reasons: high food prices and high oil prices. Oil prices have since dropped due to a fall in demand, but the high food prices remain – and both these things (unlike perhaps the financial situation) affect everybody.

As a general rule, central banks decrease interest rates to stimulate demand (but this increases inflation in the long run) or increase them to make it more expensive to borrow to cut off spending and reduce inflation (at the cost of hampering growth). Because there was originally thought to be a trade-off between output growth and inflation, it was fairly easy to predict where interest rates would go. High inflation caused by high output was reduced by increasing rates and vice versa.

In more recent times, this has been proved wrong to an extent. A few years ago, we were all enjoying steady growth and low inflation. Now we have next to no growth and high inflation (known as ‘stagflation’). So now, increasing rates to combat inflation will make growth even worse. Central banks have been cautious for a while for this reason, but have now started cutting rates everywhere.

This seems like a good idea. As I mentioned, oil prices are subsiding a bit, and food price inflation shouldn’t stay high forever (it was originally caused by a poor crop harvest due to the weather conditions last year). So cutting rates hopefully won’t do that much to inflation, but technically it will cause confidence, lending and spending to increase.

Or will it? Remember the physics book story? Banks don’t have to lower lending rates just because the central bank’s base rate is lower. They want to make a profit – so their lending rates will usually be higher than the base rate (the base rate is usually the rate that banks borrow from the central bank). Normally they maintain a certain rate differential to make a profit from. So if the base rate was 5%, then they may charge 6% (so 1.2 times the base rate). At the moment, what’s happening is that the central bank may reduce the base rate to 4.5% but commercial banks will keep their 6% rate the same in order to make extra profit to recover their losses. Hence borrowing money doesn’t become cheaper and spending doesn’t increase like the central bank wants it to.

A final point regarding inflation. Reducing interest rates makes a currency depreciate. This is because investing in it doesn’t yield as much as does investing in a country where the interest rates are higher. The pound has lost value lately, and will keep doing so since the Bank of England has reduced interest rates. This means that (keeping all other currency values constant), someone buying British goods from abroad finds them cheaper – so the value of UK exports should increase. Conversely, people in the UK will find that imported goods are more expensive than they were before.

Theoretically, this is good for a country’s output, and therefore increases the amount of wealth in the economy for everyone. Unfortunately for us, the UK is a net importer of goods. We need oil from abroad, most of our cars come from Europe, most of our electronics and clothes come from Asia, and a lot of our food comes from abroad (because we generally only have the weather to grow potatoes, wheat and apples!). So in fact a weaker pound is not that great for the UK.

Of course, if all countries reduced interest rates by the same proportion then there would be no difference. But since each country must respond to its own issues, it rarely works out this way.

The Housing Market

Housing is vital to the economy, and not just to live in. For most people, their house is their biggest asset. If it increases in value, they can suddenly find themselves much wealthier. Right now, the opposite has happened. People have just lost a lot of their stored wealth, and so they are likely to be more cautious when contemplating expenditure. As banks are not too keen on lending as it is, it is even more difficult to borrow money when house prices are lower, since a large proportion of loans are secured on them.

In addition to this, large institutions (including, but not limited to, banks) hold a lot of their assets in the form of property. A fall in its value obviously makes them worse off too.

The fall in house prices has been a long time coming – they were exceptionally high for so long it would be naive to think that they would be like that forever. It’s actually good for people struggling to get themselves on the property ladder, but since mortgages are hard to get these days – the benefit is negligible.

With the nationalisation and government investment in most of the UK and US lenders, there is hope that they could force interest rates down and approvals up.

In Closing…

I want to stress a few things. The global economy is bad because a lot of shocks have hit it at the same time. Things have been amplified by stock market crashes, but not caused solely by them as many people think.

Investment banks are largely to blame for being so reckless, but then again, some of that blame could go to regulators for letting things go without batting an eyelid.  If a drunk, drugged up murderer drives and kills himself – nobody would care. If the same guy ended up running over an innocent family, it would be a tragedy. Similarly, banks can play around with money, but if it goes wrong, all of us become affected due to the fact that they form an integral part of modern society.

The world economy was heading for a slowdown anyway. But the credit fiasco made it into a disaster. A slowdown was not avoidable, but recklessness was. Prevention has always been better than cure, and this is why policy makers are in a tough predicament at the moment. Like stopping people from drinking and driving, banks should have been stopped before all this happened. It’s too late now, but the best solution is to make sure it doesn’t happen again.