How a credit crunch may hurt the world economy

As troubles in the US housing market ripple across the global economy, the health of banks has become one of the biggest financial uncertainties for 2008.

from the January 10, 2008 edition

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Is world banking system in trouble?

Not unless things worsen dramatically, experts say.

"What you have is a sectoral problem, not a systemic problem," says Edward Kane, a finance professor at Boston College.

Some financial firms – those most exposed to the subprime home-loan sector – face much bigger losses than others. Among the hardest hit is America's Citigroup. But Citi and others are still making new loans, and have a cushion against losses. Some may need to expand that cushion by cutting dividends or seeking capital from outside investors.

In this scenario, the global economy can escape major damage.

"That's an optimistic view," Ms. Packard says. "We see it that way."

But she says a pessimistic scenario is also possible, if global economic growth decelerates more than expected. That could push down prices of many assets – real estate, stocks, and more. Bank losses would multiply, and lending would be curbed more sharply. The downward pressure on asset prices could come partly from investors such as hedge funds if they are forced to "deleverage," to sell assets to cover losses on other investments made with borrowed money.

"It's like a lake where parts of the ice are very thin" for the economy to keep skating on, Packard says.

Even the optimistic case creates some headwinds of tighter credit.

"Credit costs will likely peak in 2009 or 2010," concludes a recent analysis by the investment firm UBS. But "we do not believe in a bank Armageddon scenario – [with] widespread bank insolvency."

Why are all these credit problems happening?

In part, credit tends to ebb and flow with the cycles of the economy. Loans often turn sour when their collateral – think US home prices – gets shaky.

Packard says a structural problem arose during an era of low interest rates: Too much money – including rising cash troves in developing nations – was chasing too few solid new investments.

And to the degree that money became artificially cheap, the resulting excesses can't last, economists say. "Eventually you're going to the pay the price," says Joseph Mason of Drexel University in Philadelphia.

Analysts lay part of the blame on policymakers. The trend of deregulation, some say, created a climate where bankers innovated with too little oversight.

Other say the financial industry may have become complacent in part because history tells them that central banks will be there with a safety net if things get tough.

Finally, finance experts say that private-sector players – including the firms that evaluate security risks – often have pay incentives that skew too much toward risk-taking, not enough toward caution.

What's the solution?

It may take months, but many experts say that credit problems will diminish as banks disclose their loan losses and gradually absorb them.

In the meantime, they say the key is for central banks to play a reassuring role. The Federal Reserve has cut short-term interest rates, and many central banks globally have provided new channels of credit for commercial banks to meet their short-term borrowing needs.

At the same time, even those who support these moves are concerned that the assistance not be over-generous.

A danger is "moral hazard" – the risk that policymakers simply encourage damaging future behavior if they essentially bail out banks that got themselves into a jam.

It's natural for big financial firms to play up the sense that there's a wide credit crisis, Mr. Kane says. Banks "would rather shift as much of the loss onto the safety net as they can."

The whole economy will pay, for example, if an easing of monetary policy fans extra inflation.

Jean-Claude Trichet, president of the European Central Bank, recently talked about the need to monitor "heightened" uncertainty, and to help ensure the smooth functioning of money markets. But he also said these efforts should not conflict with holding inflation in check.

A lively debate surrounds the question of achieving the right balance. Some say that monetary easing will help ordinary workers, not just banks.

"What central banks need to do is to reduce interest rates more aggressively," Lachman argues, "to prevent the present credit crisis from leading to a steep recession which would only deepen the present crisis."

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