VoxEU Column Financial Markets

Fallout from the credit crunch

Economists can’t say: “we told you so.” Economists don’t have perfect foresight. But like doctors after the outbreak of a contagious disease – economists can tell you how the disease might spread, so that you may be better prepared. Here are some of the possible dangers ahead.

For years economists and policy makers have worried about the fragility of the US economy, and particularly about the un-sustainability of the US housing boom, but when the shock finally occurred, everyone – central banks, commercial banks, hedge funds, private investors - appears to have been unprepared. The big surprise was the nature of the shock. Suddenly banks stopped lending to one another, except on punitive terms. Liquidity dried up, threatening the existence of otherwise well-functioning banks and businesses. The crisis of confidence jumped across US borders with ease, as the recent run on Northern Rock has shown. How will this financial turbulence affect the world economy?

Economists obviously don’t have perfect foresight; so I won’t try to anticipate the future. But economists can do what doctors do after the outbreak of a contagious disease. They can tell you how the disease might spread, so that you are prepared. This is my purpose – not to make a forecast, but to warn of possible dangers ahead.

Expectations inertia

Investors tend to imagine that the world will continue to be approximately like it is now. Before the US Federal Reserve reduced the benchmark interest rate by one-half percentage point on Tuesday, September 18, financial markets were in despair; afterwards they were euphoric. Such myopia is dangerous. So far, economic activity – production, employment, consumption, investment and trade – have remained largely unaffected by the credit crunch. Many seem to believe this will continue. Equally dangerous.

If the credit crunch persists, there can be no doubt that economic activity will suffer. The Fed’s interest rate cut will not prevent US home foreclosures, nor will it eliminate the glut of unsold homes. If US house prices continue to fall and unemployment continues to rise, consumers will doubtlessly reduce their spending, and the fall in demand will aggravate the rise in unemployment, hurt the US stock market, and thus lead to a further fall in spending.

Meanwhile, it is worth keeping in mind that the US is not the only country where house prices have risen much faster, on average, than national incomes. On the contrary, house prices in Australia, Britain, Denmark, France, Ireland, Spain, and Sweden have all increased faster, over the past ten years, than in the US. Of course the US is a special case on account of its subprime mortgage lending towards the end of its housing boom. There, mortgage lenders with poor credit records could buy houses at virtually interest-free for a few years, before the rates were adjusted steeply upwards. But the danger of international contagion remains. The US housing slump may well lead investors in Europe to reassess the value of their properties. If that happens, then consumption spending is likely to fall in the countries listed above, leading to weaker labour markets.

This could happen at a time when the Chinese economy has overheated and will need to slow down, and when the Japanese economy is stagnating. There are no other countries to take-up the slack, to serve as a “motor” for the world economy, as the US has done for so long.


In short, a recession in the US is possible and this recession could spread to other countries, primarily through loss of confidence within financial markets and house price contagion. Germany, needless to say, need not worry about a housing slump, since its housing market has already been in a state of slump for over a decade. But that does not mean that Germany is immune from the dangers of the current financial turbulence. The German economy is heavily dependent on its exports, and these would clearly suffer if world economic activity declined. Furthermore, as we have seen, the fallout from the US credit crunch can affect the balance sheets of German banks.

Of course these dangers may not materialise, just as contagious diseases need not spread. It is useful, however, to know where the dangers lie.

Even if times ahead are troubled, the long run is likely to look much more settled. In the short run, a housing slump could well make private investors and central banks outside the US less eager to hold dollars. A survey by the US Treasury Department last year indicates that about third foreign-held US corporate debt consisted by asset-backed securities and about half of that was mortgage-related. Petro-dollars held in the Middle East and Russia are particularly mobile. Once foreign money leaves the US, the dollar would fall. In the longer run, US exports would rise, shrinking the huge US trade deficit. Moreover, recession in the US would lead to lower imports, further reducing the trade deficit. At the same time, China may well let the yuan rise against the dollar, leading to a rise in its domestic spending relative to its exports. Once US consumers spend less and Chinese consumers spend more, the large global imbalances, which have cast a shadow on the world economy for the past decade, would begin to disappear.

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