Magazine article Public Finance

How to Survive the Crunch

Magazine article Public Finance

How to Survive the Crunch

Article excerpt

The US philosopher George Santayana said: 'He who does not learn from history shall be condemned to repeat it.' What we've seen in the world economy in the past six months has happened before, and in all probability will happen again. The conditions that led to the credit crunch have recurred from the South Sea Bubble through to the Wall Street crash of 1929 and beyond.

So we have to look to earlier periods in history to understand the mentality that overtakes the market when it is in speculative mode. The best book on this, The great crash, was written in 1954 by economist John Kenneth Galbraith.

The similarities in conditions in the mid-1920s, early-1930s, the 1990s and early noughties were nu- merous. For a start, there were the easy credit terms with low interest rates, which allowed people to bor- row to speculate. The ability to trade on the margin al- lowed extreme positions to be taken with very little im- mediate outlay. Then there was widespread use of derivative financial instruments, which permitted a volume of trading greater than could be supported by real assets. At the same time, the use of 'leverage' cre- ated a situation where the increased value of assets was concentrated on the small amount of risk capital with proportionately multiplied returns to that capital. This was exacerbated by a high degree of interlinking between financial institutions in terms of ownership. takeovers and liabilities. Above all, in all three periods, there was an absolute certainty that economic growth was without end and the value of assets could rise without limit

In this case, it is unsurprising that the credit crunch so far mirrors the pattern of the crash of 1 929. First, the drop in the real economy preceded the collapse of the financial and stock markets. During the last boom, funded by consumer credit, the limit of what could reasonably be afforded was reached. The asset price inflation began to eat into peoples ability not only to fund their current consumption, but in some cases to actually function in the local economy. The hike in energy prices merely exacerbated an existing tendency.

Secondly, the downturn in the real economy was enhanced and amplified by the financial and stock markets. As increased margin calls to cover debts were made, the leverage - which had enhanced returns worked dramatically in reverse to amplify losses. The interlinking between financial bodies transmitted the growing tide of liabilities, so an adjustment became a downturn, became a recession, and might yet prove to be a depression.

Thirdly, the contagion of the financial and stock markets was then, and is now, being transmitted back to the real economy as a modern equivalent of 'Gresham's Law', where bad assets drive out the good. To pay for losses on the 'toxic assets', assets with real value have to be sold and that deprives the real economy of the funding necessary to continue its activities. The people more likely to be involved in the speculative activity, using their surplus income generated by an increasingly uneven distribution of income, now have to curtail their consumption to fund the drop in asset values on which they depended. Eventually, the whole economy settles to a new, lower equilibrium level.

There are, however, ways in which finance officers and treasurers can lessen the implications of the credit crunch. The tips set out below are a distillation of the collective wisdom of a number of senior colleagues. They cannot, of course, be comprehensive. In a few years' time, with the benefit of hindsight, they might look irrelevant but at present they are the vital issues.

Tip one: prepare/or the long haul. The effects of the credit crunch might last longer and be deeper than you anticipate and some analysis, in particular about cash flow, needs to be undertaken. If things do go on for longer than expected then the current level of debt being used to finance interventions is going to start to have an impact on the public sector's ability to fund services in the future. …

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