Dreaded R-word becoming commonplace

By Neil Behrmann

September, 2007:- THE dreaded R-word is now becoming commonplace as the complex sub-prime and credit crisis takes hold in the US and Europe.

The International Monetary Fund (IMF) and the Organisation For Economic Development (OECD) have cut their US and global growth forecasts. Blue Chip Economic Indicators surveyed 50 economists who believe that there is a one in three chance that there will be a recession in the US. A tiny minority predict that it will spread to Europe and parts of Asia.

The global economy's prospects can no longer be divorced from the banks' credit crunch. The crisis is the result of excessive lending, not only in the US but in Europe, China and other parts of Asia.

American, British, French, Spanish and Italian consumers, comfortable with the rising value of their homes, borrowed as much money as possible to finance spending on a variety of goods and holidays. Huge flows of money poured into stocks, real estate and commodities. Hedge and private equity funds and other speculators leveraged themselves to the hilt. They borrowed excessive amounts to trade and purchase a variety of inflated assets.

The event that changed business and market sentiment

The Bank of International Settlements and economists such as Brendan Brown of Mitsubishi UFJ Securities International and Stephen Roach of Morgan Stanley warned of the excesses.

So did Yale's behavioural finance professor Robert Shiller. But in the heady final phases of bull markets, participants are only too happy to cast derision at their views.

As so often happens during rampant speculation, a single, relatively unimportant event, has changed the course of the market. The June collapse of two Bear Stearns hedge funds precipitated the current credit crunch.

Compared with the trillions that wash around the financial markets and much bigger recent hedge fund collapses, the US$1.6 billion bankruptcy seemed 'small potatoes' as the Guys & Dolls humorist Damon Runyon put it.

But those funds had borrowed US$10 billion to US$20 billion and punted on sub-prime debt and other junk. Their failure made the market stop and think. How many others were caught? The result was a vicious circle.

Banks began to scrutinise their credit lines to hedge funds, forcing them to dump assets, causing price declines, losses, investor withdrawals, loan reductions, more sales and hedge fund closures.

The jittery state of the markets indicates that the circle is still turning, although bargain hunters are precipitating rallies from time to time.

Credit withdrawals willl raise heat

The big question for the global economy is to what extent will banks rein in credit and put the screws on consumers and businesses.

Goldman Sachs, Morgan Stanley and several other investment banks are taking a sanguine view. They believe that there will be a downturn in the US economy, but interest rates and the US dollar will fall.

A recession is unlikely and Europe and Asia could well decouple from the US. The proverbial American sneeze will not be contagious.

Tighter credit and higher interest rates have already brought about a slide in American real estate prices. Mr Brown of Mitsubishi UFJ Securities International contends that the decline is already dampening business and consumer spending and a recession has already begun.

Most economists and the financial press are examining dated statistics, so they wrongly believe that the US economy is yet to turn downwards, contends Mr Brown.

Chances of real estate slide in UK and other European nations

Prof Shiller of Yale, who predicted the current American property slump, the worst in 16 years, agrees with Mr Brown that Europe cannot be isolated from American economic trauma.

He believes that there is a 'substantial probability' that the housing slump in the US could well spread to the UK. There are 'remarkable' similarities between the property markets in cities such as Boston and Los Angeles and British cities, he says.

'People are so accustomed to rising house prices, they do not believe it when someone tells them it will come to an end . . . What we have may be the makings of an economic crisis,' maintains Prof Shiller.

'Other countries that are vulnerable to a property slide are Spain and France,' fears Mr Brown. Banks there are exposed.

Other economists fear that high European exchange rates and tighter credit are already denting the German economy. Saudi officials are worried that high oil and gasoline prices could be pushing some countries toward recession. Since Asia is dependent on exports to the US and Europe, any downturn there would have an impact. It seems the day of economic reckoning is at hand

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