One of the big victims of the credit crunch is the United Kingdom, which I didn’t mention in my previous post on the “turbulences” below Davos. The Northern Rock debacle, where the British mortgage lender suffered an embarrassing run and was rescued by the British authorities to avert a general banking and financial crisis was a shock to the nation and the rest of the world. It is also putting into question a model of growth based among others on an enormous housing bubble. The United Kingdom has witnessed almost a decade and a half of economic growth, with an impressive dynamism. This dynamisms was the result of the long-term effect of Margaret Thatcher’s market reforms and Gordon Brown’s impressive track record as savvy macroeconomic manager at the Exchequer. Today, this track record is in question.
What is going to happen to “hedge fund” Britain, which borrows short, invests long and makes lots of money in the meantime? (The term was coined by Martin Wolf in an analysis in 2006 of the UK economy. No longer available online, apparently, and at this very moment of writing the FT.com search engine is having problems…).
The IMF forecasts growth of 2.3% for the UK economy in 2008. Will a recession blow away this relatively optimistic outlook? Not many really believe it, not even opposition politicians. Anyway, the crisis is a true stress test for the UK economy.
But there is no doubt that the issue is putting into question the UK’s financial services regulatory model, which until recently was seen as the global benchmark. Whoever wants to understand quickly the current subprime mortgage crisis better please do read this post by Bordo on Vox.EU.
“Many of the financial institutions and instruments caught up in the crisis are part of the centuries old phenomenon of financial innovation. The new instruments –often devised to avoid regulation – are then proved to be successful or not by the test of financial stress such as we have been recently encountering. The rise and fall of financial institutions and instruments occurs as part of a lending boom and bust cycle financed by bank credit. The credit cycle is connected to the business cycle.”
Lesson #1: Anna Schwartz once made a distinction between real financial crises, defined as a scramble for liquidity requiring lender of last resort action and pseudo crises( asset busts leading to wealth losses) which do not require the lender of last resort. The recent wealth losses by hedge funds and others represent pseudo crises.
However the spillover of the subprime crisis into the interbank loan market and the freezing of liquidity to the banking system has posed the threat of a real crisis and have been dealt with properly by the ECB and the Federal Reserve. By contrast the Bank of England initially followed a strict Bagehot policy of keeping its discount window open at a penalty rate. The run on Northern Rock on September 14, 2007 and the Bank’s apparent volte-face likely did not reflect the failure of the Bank’s lender-of-last-resort policy but perceived inadequacies in the UK’s deposit insurance, the lack of coordination between the Financial Stability Authority and the Bank, and political pressure.
For the moment other European countries are not being hit that badly by the crisis. I personally found it interesting to be reminded that this crisis is one triggered by financial innovation, in this case, by the highly successful “asset-backed securities”. Interestingly, this crisis hits the US and the UK, economic models that tend to put innovation and dynamism at the heart of their system. Ironically, being spared the crisis in say, Germany, or France (hit by the SG crisis, but this is yet another issue) is not necessarily a good sign. Where nothing happens, not much can happen, can there…?