Credit crunch: Are we wiser two years on?

In London, the sun was shining, the banks were lending, the shops were busy.

The start of August 2007 was going swimmingly well, or so it seemed.

The mild euphoria that accompanied the long holidays fed into the mood of the nation. There was quiet optimism that house prices would continue rising, though perhaps more slowly, and many dared to believe in new Prime Minister Gordon Brown, who confidently declared that the boom-to-bust economic cycles which had devastated economic life in the 1970s and 1980s were a thing of the past.

But on August 9, French bank BNP Paribas revealed it was struggling to value some of its mortgage-backed assets, sparking panic in the financial markets.

The credit crunch had begun, with banks refusing to lend to each other, or to businesses and consumers.

On the same day, the European Central Bank (ECB) and the US Federal Reserve injected US$90 billion ($134 billion) into the system to allow institutions to meet their short-term credit commitments and bolster confidence. Former Northern Rock bank boss Adam Applegarth said it was 24 hours when "the world changed".

What happened two years ago was to lead to a chain of events that involved the nationalisation of about half the major banks in Britain and the United States. It was also to lead to the collapse of emerging markets from Latvia to Pakistan and the biggest-ever globally co-ordinated government rescue package, involving trillions of dollars.

The world is now an uglier place, with mass unemployment, widespread business failures and dramatic falls in world trade. A swift political response may have staved off the horror of another 1930s-style Depression, but the data suggests that this is the worst slump for the past 80 years.

Richard Snook, senior economist at the Centre for Economic and Business Research, says: "This is a saxophone-shaped recession. The long neck represents the sharp fall in output over the last year, then a gentle recovery that falls far short from where we started."

Others are even more wary. Gerard Lyons, chief economist at Standard Chartered, fears that there could be another leg to the financial crisis as "many official bodies have inferred that there is a big shortfall in what the banks have written off so far, and what the losses really are".

But if British residential property prices start to edge up consistently and confidence returns to the banking industry, it may be possible to conclude that government - which is pump-priming the economy via expanding the money supply - has saved the day. What should not be forgotten, however, is that the authorities have largely transferred losses from privately run, domestic financial institutions to the public balance sheet. That stores up potentially explosive problems for the future as national debt levels rocket and the country finds itself with humongous borrowings that will take years to repay.

Vince Cable, the British Opposition Liberal Democrats' respected Treasury spokesman, says: "There are unpopular choices ahead for whoever wins the next election, and doubtless there will be serious political repercussions."

Not that the onset of the credit crunch came as a total surprise.

There were warnings from the Financial Services Authority and Bank of England that the housing bubble could burst and that stockmarkets were not pricing in risk. Some economists flagged up the huge amount of debt that banks and consumers were taking during an era when interest rates had been relatively low.

There were the "imbalances" in trade with the Americans and Europeans sucking in imports from the east to satisfy their insatiable appetite for goods and services.

Lyons says: "At the time, I was getting a lot of stick for suggesting that US interest rates would have to be cut, rather than raised to ward off inflation ... the nub of it was that I thought the US economy was far more fragile than it appeared."

The collapse of Northern Rock in September was followed in 2008 by the US-government inspired rescue of Bear Stearns, the rescue of HBOS by Lloyds after prodding by the British authorities, the demise of RBS and Bradford & Bingley and the takeover of Alliance & Leicester by Spain's Santander.

Then it got worse. The bankruptcy of Lehman and rescue of American insurer AIG last September saw the world's banking system brought to the point of destruction.

Lyons says: "Only at that point did we all fully realise how tightly the financial world was linked up, with institutions feeding off each other, and that if one big bank went down, so did everything else, a bit like a pack of cards."

A shadow banking system had built up whereby banks bundled up poor quality loans, mixed them with some good quality mortgages, and sold the package of debt (the components of which were unknown to investors) in a process known as securitisation, with many products wrongly graded by the credit rating agencies.

Now, after a rally in world stockmarkets that began in March, and a return to health of some US investment banks (with employees on target to receive big bonuses), the question is whether we are over the worst.

Vicky Redwood at Capital Economics believes we have hit rock bottom and are on the road to a sort of recovery, "but it will be sluggish and fitful". Howard Archer at Global Insight says that "progress will be painfully slow; the banks still aren't lending and that hasn't shown up in recent data".

Jim O'Neill, chief economist at Goldman Sachs, admits: "We simply can't be confident of the answer, but overall our indicators imply that we could see some modest positive world GDP growth before the year is over."

But Cable argues that this is "a very profound financial crisis", and worries that lessons are not being learned: "Six months ago there was unanimity that we needed a global approach to banking regulation and we should break up the big banks and clamp down on bonuses.

"But it seems that, both here and in the US, we are going back to the status quo ante - and that doesn't bode well for the wider economy."

Be warned.

BEFORE AND AFTER
How the rhetoric was transformed by the credit crunch.

I don't think there's any real evidence here of a fundamental challenge to the macroeconomic outlook.
- Mervyn King, August 2007

The UK is in a deep recession ... Restoring both lending and confidence will not be easy and will take time.
- Mervyn King, February 2009

The fundamentals of our economy are strong ... and we are headed for a soft landing.
- George W. Bush, August 2007

If money isn't loosened up, this sucker could go down.
- George W. Bush, September 2008

People should have confidence that many of the investments they make will be good investments.
- Alistair Darling, August 2007

Times are arguably the worst they've been in 60 years ... it's going to be more long-lasting than people thought.
- Alistair Darling, September 2008

I think there was to some extent a bit of an exaggeration around the seriousness of what is occurring.
- Michael Cullen, August 2007

What we thought we knew even five months ago has been overtaken by events. The rainy day has now arrived.
- Michael Cullen, October 2008

- OBSERVER