Historically, October has been a dangerous month for the world economy. The Wall Street Crash took place in October 1929. That led to a depression lasting over ten years.
Black Monday saw stock markets around the world crashing in October 1987, though its impact lasted only about two years. The latest fiasco – the Great Panic in 2008 – again started in October. It has still to run its course and there may yet be more to come.
A number of factors are worrying observers. The Eurozone crisis is continuing to send shivers down the spines of many analysts. They fear that time is running out and that it could only be a matter of weeks rather than months before it turns into a catastrophic avalanche. Greece remains the probable starting point.
By now, Athens should have received eight billion euros from the so-called Troika – a group made up of the International Monetary Fund, the European Commission and the European Central Bank. The money would be used to pay public sector workers and keep public services going. But talks are still going on, with the parties discussing the conditions for the bail-out and the total sum involved. If there isn’t a cash injection in time, there will inevitably be chaos in Greece.
However, Greece isn’t the only worrying country. Italy has seen its sovereign credit rating cut from AA to A+ by the ratings agency Fitch – which also cut Spain's rating from AA+ to AA-. The reason given for the decision focused on high debt and poor growth prospects for both countries. Fitch added that the move reflected the worsening of the Eurozone debt crisis and the bleak outlook for the region. Fitch is the third agency to downgrade Italy following both Standard & Poor's and Moody's.
At the end of last week, Moody's downgraded the debt ratings of a dozen British banks. The agency said it reflected doubts over the strength of government support if they got into future financial problems. Some of these banks are facing yet more uncertainty after the US Federal Housing Finance Agency launched a multi-billion dollar lawsuit last month over the banks' packaging and selling of mortgage-backed securities in the run-up to the global financial crisis.
The agency wasn’t just after British banks, such as Royal Bank of Scotland, HSBC and Barclays. It is also suing another 14 banks from the United States, Germany, Switzerland, Japan and France. The size of the claim is an eye-watering $196bn. The lawsuit alleges negligent misrepresentation, securities laws violations and common fraud over the way the banks issued, bundled and sold mortgage-backed securities to government-sponsored enterprises.
There is a serious worry that this case could take years to resolve. It could lead to a state of paralysis in the boardrooms of the banks involved. It could affect interbank lending, meaning that the banks' credit supply dried up and liquidity evaporated. That could further damage global economic growth and world trade.
The combination of the Eurozone crisis, the lawsuit and continued pressure on the banks – remember that the first banking casualty has already happened with the Belgian bank Dexia having to be nationalised by the government there – could mean that the low-growth we are seeing at the moment could continue for much longer than forecasters have so far being predicting. This is no ordinary downturn when the banks are in as much trouble as the rest of the economy.
The only answer that the Bank of England’s monetary policy committee (MPC) has come up with is a further round of quantitative easing (QE), injecting some £75bn into the economy to try to stimulate growth. The trouble is that QE means printing money, with the Bank creating electronic money in a digital account.
The economic theory says that this extra money can stimulate the economy. The first round of £200m two years ago was used to buy government bonds, making it cheaper for government and corporations to borrow money. This time, the Bank says it will buy gilts – a form of secure bond with a guaranteed return.
Again the theory here is that the institutions which hold the gilts – banks, pension funds, insurance companies etc – will invest the money from the sale elsewhere. The banks, for instance, could use the money to lend to house-buyers and struggling businesses. The idea is that the move should encourage a rippling effect of transactions through the economy.
However, critics of QE say that the first round had little impact on economic growth, so why should this one be any different? They warn that injecting cash into the economy will simply push up inflation, leading possibly to “stagflation” where inflation rises but growth remains low or non-existent. And the Bank’s decision will push up the price of gilts, lowering their yield. This has a double-edged effect. On the one hand, lower yields reduce the cost of borrowing for businesses and households; on the other, it could further reduce the expected income of pensioners in the future.
Nonetheless, David Kern, chief economist at the British Chambers of Commerce, welcomed the decision. "In the face of the risks facing Britain’s recovery,” he said, “it is important to make every effort to underpin business confidence and avoid a setback. However, higher QE on its own is not enough, and we urge the MPC to look at other radical methods. The chancellor’s intention to use credit easing methods to help stimulate the flow of credit in the economy is a welcome initiative, but its implementation will take time and the MPC is better placed to move more quickly.”
That view was shared by both the Institute of Directors (IoD) and the Confederation of British Industry (CBI). Graeme Leach, the IoD’s chief economist said: “What did we want? More QE. When did we want it? Now. Near zero GDP [gross domestic product] and money supply growth made a compelling case and the Bank of England was right to launch QE2. It could be argued that the Bank of England was slow to introduce QE the first time, but thankfully it hasn’t made the same mistake twice.”
Ian McCafferty, chief economic adviser to the CBI, added “With the risks to the economic outlook increasing, the MPC has acted promptly by extending quantitative easing this month. This measure will help support confidence, but we need to recognise that its impact on near term growth prospects is likely to be relatively modest. Only once the turmoil in the Eurozone is resolved will confidence be fully restored.”
Contrast that with Tom Clougherty of the Adam Smith Institute, who said that “more quantitative easing means more kicking the can down the road. It means preventing markets from adjusting, and it means perpetuating the misallocated capital, excessive risk-taking, and over-leveraged balance sheets that got us into this mess in the first place. To put it simply, printing money does nothing to solve our current problems. If anything, it makes them worse.”
Joanne Segars, chief executive at the National Association of Pension Funds, accepted that a strong and growing economy was essential for the long-term sustainability of UK pensions. But she warned that “this measure has adverse consequences for pension funds in the short-term. QE makes it more expensive for employers to provide pensions, and will weaken the funding of schemes as their deficits increase. All this will put additional pressure on employers at a time when they are facing a bleak economic situation.”
However all this may simply be academic if the Eurozone crisis continues to worsen. The UK is not immune from the contagion given both the levels of Euro debt held by British institutions and the fact that the EU is one of our largest trading partners. We should know a little more about what the future holds within the next few days or weeks.
Will we breathe a sigh of relief? Or will a flock of “black swans” dive out of the clouds changing all our economic expectations and assumptions? Remember: October can be a dangerous month for the world.
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