Why bust will always follow boom

Have the world’s central banks done enough to save the global economy?

The answer from the markets yesterday was a resounding ‘no’. The FTSE 100 collapsed by nearly 200 points, diving to 6,364, as interbank lending rates failed to fall as sharply as investors had hoped.

Meanwhile, even as markets were worrying about an economic slump, consumers are more worried about inflation than ever before. Households expect prices to rise by 3% over the next year. That’s a full 1% above the Bank of England’s target of 2%, which suggests that people have no faith in the Bank’s ability to deliver.

It’s becoming clearer by the day that central banks have lost control of the only real lever they have to influence the economy. But that may be no bad thing.

At least they can’t do any more damage…

A central banker reveals how the credit crunch works

Paul Tucker, a member of the interest-rate setting Monetary Policy Committee said that the Bank of England and its international counterparts were trying to stop the credit crunch from spreading to the ‘real’ economy.

“There is no doubt credit conditions for both households and firms have tightened. We must try to avoid a vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply and slower aggregate demand feed back on each other.”

Let’s have that again, this time in English.

“It’s getting tougher for people to borrow money. Lower borrowing means falling asset prices (if you can’t borrow five times your salary to buy a house anymore, then the price of the house has to fall until you can afford it). If asset prices fall, then people don’t have as much wealth to secure credit against and banks and firms need to write-down their balance sheets. And less credit means they can’t spend as much – and that means we’re all in trouble.” Somehow, Mr Tucker reckons, the banks have got to stop this from happening by re-inflating the credit bubble, basically.

I’ve got news for Mr Tucker. It won’t work.

The best way to cure a hangover – start another one

The bursting of a bubble is just like a hangover. You can pop a few painkillers and accept you’re going to have a miserable day. Or, if you lead a slightly more rock’n’roll lifestyle, you can try to postpone your hangover by getting drunk again – although that just means your headache will be even more blinding when it eventually hits you.

Either way, the end result is some level of pain. There’s only one way to avoid a hangover altogether – and that’s not to get drunk in the first place.

A credit boom is the same. If you spend too much at Christmas, you can rein it in during January and tighten your belt for a few months. Or you could just not worry and keep whacking your spending on the credit card – but for every extra penny you spend, you’ll eventually have to tighten your belt further and for longer.

The money doesn’t just come from nowhere – it comes from the future. What you borrow to fuel consumption today, you have to pay back tomorrow. That’s not saying there’s anything wrong with credit – you just have to remember how it works.

What goes up, must come down

But people and institutions have borrowed and loaned so much partly because central banks allowed them to believe in a consequence-free world. Money was so ridiculously cheap and came so easily that it seemed stupid to save it.

House prices would rise forever, so it didn’t matter what price you paid – the government and Alan Greenspan and Mervyn King would never let them fall. And because house prices would rise for ever, it didn’t matter how much you loaned to someone, because if the loan went bad you could always repossess the house and it would be worth far more than you’d lost in bad debt. Better yet, you could sell the debt to someone else and never have to worry about it at all.

But the subprime collapse reminded lenders that sometimes money doesn’t come back. And now suddenly money has become a much more attractive asset to hold onto. The central bankers are tugging on all the levers they can pull, and nothing’s happening. It turns out that the laws of physics haven’t been repealed. What goes up, must come down. What was borrowed, must be paid back. And bust follows boom, as sure as night follows day.

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Turning to the wider markets...  

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Sharp falls for London shares

In London, the FTSE 100 tumbled nearly 200 points yesterday as credit concerns troubled investors on both sides of the Atlantic. The blue-chip index ended Thursday 195 points lower, at 6,364. Rentokil was the day's heaviest faller, losing one-fifth of its value as profits for its CityLink parcel division came in well below forecasts. Packager Rexam was also lower as it warned that the higher oil price would hit profits this year. For a full market report, see: London market close

On the continent, shares also closed sharply lower. The Paris CAC-40 lost 152 points to end the day at 5,590. And in Frankfurt, the DAX-30 closed 147 points lower, at 7,928.

Across the Atlantic, a positive 2008 forecast from manufacturer Honeywell prompted an afternoon rally that cancelled out early losses. The Dow Jones ended the day 41 points higher overall, at 13,518, after an earlier drop of 100 points. The S&P 500 was one point higher, at 1,488. But the tech-rich Nasdaq shed 2 points to end the day at 2,668.

In Japan, data revealing falling corporate sentiment hit banking and property stocks hard, but the benchmark Nikkei index nonetheless managed to add 22 points to end the session at 15,514. In Hong Kong, the Hang Seng closed down 180 points at 27,563.

Centrica in-line despite rising gas prices

Crude oil had risen to $92.90 this morning. And Brent spot was at $93.16 in London.

Spot gold extended yesterday's falls this morning and hit an intraday low of $796.60 before climbing back up to $802.60. Silver, meanwhile, was at $14.16.

Turning to the forex markets, the pound was at 2.0347 against the dollar and 1.3968 against the euro. And the dollar was at 0.6863 against the euro and 112.5 against the Japanese yen.

And in London this morning, British Gas owner Centrica forecast in-line full-year earnings, despite the rising price of natural gas. Although the rising cost of wholesale gas has reduced margins, rate cuts aimed at winning back domestic customers appear to have paid off. Centrica shares were little-changed so far today.

Finally, our recommended articles for today...

Is this the real reason for the central banks' new plan?
- On Wednesday, five central banks announced co-ordinated action to deal with with banks' reluctance to lend to one another. Yves Smith looks at reaction to the decision and reflects on why the central bankers chose the strategy they did here: Is this the real reason for the Central Banks' plan?

Biofuels subsidies push up price of beer
- Not only is your pint of lager about to get more expensive, the shot of tequila you might want to have afterwards is also going to rise in price. And it's not just drink, all kinds of foodstuffs are also going to become more expensive. For more on why misguided government subsidies are to blame, read: Biofuels subsidies push up price of beer

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