Fallout Fears As Sub-Prime Crisis Seems Far From Over

Source : The Business Times, September 27, 2007

REALITY intruded amid the 'dreaming spires' of Oxford last week when university dons came together with business, leaders, government officials and others to debate the state of the world. The inter-disciplinary discussion produced a sobering assessment of prospects for the global economy in the wake of the meltdown of the US sub-prime mortgage market and its spreading consequences.

The consensus view among those attending the annual Oxford Analytica international conference held in Christ Church College was that the crisis is far from having run its course.

There are many channels through which the sub-prime market problems will continue to make their effects felt throughout the US economy and on into the global economy, it was argued.

Most people are too preoccupied with the immediate consequences of the crisis, in the shape of financial system stress, to give very much thought to the longer term fall-out on the global real economy. But the tranquil setting of the centuries-old Christ Church College encouraged those gathered there to take a longer term perspective.

The sub-prime crisis will be a drawn-out affair whose ultimate outcome is hard to predict, it was felt, given that it is happening within a different context to previous crises. Emerging market crises in Asia and elsewhere 10 years ago had only a limited impact upon developed economies, but this one has originated in America, the heartland of capitalism.

The US is also the locus of consumption that has powered a remarkable expansion of the global economy in recent times, enabling China and India as well as Brazil, Russia and other emerging economies to join up.

This suggests strongly that while we are looking at a financial 'event' now, the crisis is destined to spread with an awful inevitability into the real economy.

This chain of causation will begin with a slowdown in US consumer spending, one former economic adviser to ex-president Bill Clinton said in Oxford. US house prices are falling for the first time in postwar memory and mortgage withdrawal to finance spending is dropping sharply along with those prices. Housing sector employment is dropping too and all this means that the chances of a US recession are rising sharply.

That would naturally impact the consumption that has allowed Asia and other parts of the world to achieve huge trade surpluses and to accumulate vast foreign exchange reserves in the process.

There is a more insidious threat, however, than an autonomous slowdown in consumption and that is protectionism. As one former administration official remarked in Oxford, if Democrats take control of the White House in the presidential election 'you can count on some sort of anti-China legislation'.

This, he suggested, could cause 'real stresses in world trade' and especially as the world can expect, at best, a 'long period of reduced growth in the US'. This highlights the missing link in most people's calculations of the wider impact of the sub-prime meltdown.

They see the linkage to the global economy as primarily a financial one, capable of being contained by central bank action whereas it is in fact the trade linkage that is more important.

Not that financial system shocks will not be serious enough in themselves to cause a lot of damage, it was suggested. For the moment, the focus is on damage caused to the profit and loss accounts or balance sheets of investment banks, hedge funds and commercial banks via money and capital markets.

But the real pain will come on the lending side.

Banks will be tougher in extending credit, resulting in a fall in the rate of credit expansion and further exacerbating the decline in personal consumption in the US and elsewhere. A drop of 0.5 per cent - or even one per cent - in US short-term interest rates will 'not help the real economy', one economist suggested at the Oxford meeting. It will help only to oil the machinery of Wall Street in the current liquidity crunch.

It is at this point that many people take heart from the notion that demand has become self-sustaining, or close to self-sustaining within Asia.

This remains very much an unknown quantity however. Certainly, emergent middle classes in these merging markets have been giving a considerable boost to demand there but this has taken place against a background of buoyant export demand and consumer confidence.

ANTHONY ROWLEY
Tokyo Correspondent