Credit crisis

Larry Elliott

On the face of it, there was nothing especially memorable about August 9 2007. With the holiday season in full swing, Britain was in relaxed, even soporific mood. House prices were rising, unemployment was falling, the economy was growing at an annual pace in excess of 3%. Gordon Brown, prime minister for six weeks, was enjoying a honeymoon with the voters and Labour had a 10-point lead over the Conservatives. The sports pages were full of cricket and the build-up to the new football season.

It was, however, the day the world changed. As far as the financial markets are concerned, August 9 2007 has all the resonance of August 4 1914. It marks the cut-off point between "an Edwardian summer" of prosperity and tranquillity and the trench warfare of the credit crunch - the failed banks, the petrified markets, the property markets blown to pieces by a shortage of credit.

On that day, the European Central Bank and the US Federal Reserve injected $90bn (£45bn) into jittery financial markets. But two days later, Gordon Brown said Britain was in "as good a shape as it could be to weather the storm".

It has turned out rather differently than he expected. The anniversary of the credit crunch this week is marked by house prices falling at their fastest rate on record, consumer confidence at rock-bottom and looming recession. Brown could soon join the growing list of those losing their jobs.

Alistair Darling, who has had the most troublesome first year as chancellor since Denis Healey in 1974, says that nobody expected the seizing up of the markets in August last year to have such profound consequences. Mid-September, which marked the 15th anniversary of the speculative attack on the Bank of England precipitating Britain's departure from the exchange rate mechanism and condemning the Tories to a generation in opposition, saw queues for three days outside branches of Northern Rock - the first run on a leading high street bank since the demise of Overend, Gurney & Company in the 1860s.

Even then, optimists were telling the chancellor that things would start to pick up in the first three months of this year, or at worst in the second quarter. Darling, one of the Cabinet's Eeyores, took a more cautious view but even he has been surprised by the length, depth and breadth of the crisis. This week, the chancellor is in temporary control of the country while Brown is on holiday; next month he and his boss plan to announce a recovery plan designed to show that Labour has not lost control of events.

It will be no easy task. Firstly, this is a different sort of war. Labour had its economic problems during its first decade in power, but in retrospect they were skirmishes rather than full-scale battles. The years leading up to August 2007 had seen the development of new and sophisticated ways for the financial markets to make - and, as has subsequently been revealed, lose money. Consumers in the US and Britain were living beyond their means, borrowing money to buy houses and fund their spending habits. Asset prices - particularly the cost of homes - rose rapidly, presenting seemingly insurmountable problems for first-time buyers. Lenders solved this difficulty by relaxing criteria for granting a loan. They then bundled up the poor-quality loans, mixed them up with some good-quality mortgages, and sold the packages of debt in a process known as securitisation. By the summer of last year, the money raised through securitisation was funding more than half of Britain's home loans.

Warnings came thick and fast from the International Monetary Fund, the Bank for International Settlements, the Bank of England and others that markets were not taking the risks of this business seriously enough. The biggest risk was a steep fall in house prices, since securitisation was based on an assumption that any problems faced by squeezed borrowers would be massaged away by strong property markets.

By last summer, it was clear that the housing market in the US was in free-fall and that mortgage-backed securities were worth less - a lot less - than those holding them imagined. With nobody sure how big the losses might eventually be, the markets abruptly lost the two ingredients vital to keep them vibrant - confidence and trust. Banks first stopped lending to one another, then sought to repair their finances by cutting back on lending to their customers. Borrowing became harder to arrange and more expensive - the classic definition of a credit crunch. Cheap and easy credit has been the lubricant for both the US and UK economies in recent years; without it they have started to seize up.

The second big problem for policymakers, not just in Britain but around the world, is that they are fighting a war on two fronts. Central banks and finance ministers are grappling not just with the credit crunch, but also with rising inflation. On August 9 last year, crude oil was trading at just over $70 a barrel; it peaked last month at more than $145 a barrel and still stands at over $120 a barrel. Rising food prices have also pushed up the cost of living, making it harder for central banks to justify cuts in interest rates - traditionally the first line of defence in a credit crunch.

The US Federal Reserve has been the most aggressive, cutting its key lending rate from 5.25% to 2%, but the Bank of England and the European Central Bank have been far more circumspect. Threadneedle Street has shaved 0.75 points off borrowing costs in but has not moved since April and with rising energy bills likely to push inflation close to 5% in the coming months is thought more likely to raise bank rate than cut it when the Bank meets this week.

Time and again hopes have risen that the crisis might be coming to an end. Last August, it was seen as just another bout of turbulence in the financial markets (the story took more than a week to become the lead story in the Guardian); then there was the hope that the run on Northern Rock was a catharsis.

In December the intervention by the world's leading central banks to unblock money markets was seen, if not as the beginning of the end, as the end of the beginning. The Federal Reserve bail-out of Bear Stearns in March was accorded the same status, as was last month's rescue for the pillars of the US mortgage market - Freddie Mac and Fannie Mae.

False dawns

One hopeful sign is that the wholesale money markets appear gradually to be returning to normal, with banks less wary of lending to one another. Emergency packages from the central banks have helped, but the repeated false dawns have made policymakers cautious about claiming victory.

With evidence that the crisis is spreading from the financial markets into the economy at large, those who claimed "it will be all over by Christmas" have fallen silent. The Bank of England says the story is still unfolding, seeing its job now as to re-shape Britain's financial regulatory system so that - in the words of one official - there is a gleaming new fire engine in the garage - and no prospect of a fire for a few years.