FROM BEAR STEARNS TO RECESSION

'Time is running out for the Federal Reserve' was the blunt assessment in early April 2008 as The Credit Crunch went to print. Borrowing costs, in particular mortgage rates, had to be targeted and driven lower, through a mixture of deep rate cuts and quantitative easing. Otherwise, more banks would fail and depression could follow recession. Delay would prove costly.

Governments and central banks had to act quickly to prevent debt deflation from taking root. But after a bankrupt Bear Stearns had been sold to JP Morgan in March 2008, policymakers and politicians sat back. They did little to arrest the downward spiral in house prices and the inevitable slide into deep recession. Bear Stearns was a one-off, they thought. They switched tack, fretting about inflation when the real threat was the Japanese curse of falling prices and multiple banking failures.

That was hard to square with the evidence. By the time the US had lost the first of its five major investment banks, 238 mortgage companies had already gone out of business. More banks were certain to fail if the Federal Reserve did not try to stabilise the property market. Bad debts would continue to accumulate causing shareholders to flee banks and sparking depositor runs.

Federal Reserve Chair Ben Bernanke has since claimed that the Federal Reserve 'responded aggressively to the crisis since its emergence in the summer of 2007'. The policy response was 'exceptionally rapid and proactive' in historical comparison, he has argued.

The Fed had allowed money supply to contract during 1930 and 1931, amplifying the initial fallout of the stock market crash a year earlier and turning a recession into depression. The contrast with the supposedly more proactive policy adopted from the summer of 2007 onwards showed the Fed had learnt the lessons that would prevent another economic slump.

In reality, Ben Bernanke's Fed made precisely the same mistakes that fuelled the Great Depression. Huge numbers of banks defaulted a year after the stock market crash in 1929, notably in Missouri, Indiana, Illinois, Iowa, Arkansas and North Carolina. In November 1930, 256 banks failed and a month later another 352 banks collapsed, including the Bank of United States. Very little was done to prevent their demise.

The decline in money supply was driven by the loss of these banks. As they failed, credit suddenly became scarce and the decline in asset prices accelerated. More banks collapsed and the economy spiralled deeper into recession.

In this critical respect, the latter months of 2006 and early 2007 were no different from 1930 or 1931. The implosion of so many mortgage originators from 2006 onwards similarly accelerated the decline in the availability of credit. The failure of the Federal Reserve to act when these lenders collapsed turned what might have been a soft landing into a crash.

Indeed, it is perhaps notable that Ben Bernanke claims the summer of 2007 marks the starting point of the crisis. For many financial market participants the crisis began in February 2007 following profit warnings in the US from HSBC and New Century Financial. For huge numbers of US homeowners struggling to meet debt repayments, the problems started two years before that. Indeed, sub-prime borrowers were in trouble even before interest rates started to rise during 2004.

Federal Reserve data should have alerted the US authorities to the risks of a hard landing. At the peak of the boom in Q3 2005, $631.5 billion of new mortgage-backed bonds were issued to fund the lending frenzy. Throughout 2006, the pace of issuance dropped progressively. By the third quarter of 2006, it had already fallen by nearly a fifth. As mortgage originators started to fold, issuance fell sharply in the final quarter, by just over a third from a year earlier. And it carried on sliding during the first half of 2007.

By the third quarter of 2007, the disappearance of so many lenders, combined with a reluctance of investors to buy mortgage bonds, had caused issuance to collapse to minus $232.4 billion (see Figure 1.1). Mortgage funding from these bonds – a critical driver of the housing boom – had not just slowed. It was contracting.

This was a stunning reversal and without precedent in modern times. It represented a shrinkage and collapse of money supply similar to that seen in the first year of the Great Depression. History was repeating itself.

The Inflation 'Crisis'

The Federal Reserve governors of 1930 and 1931 were also unwilling to support the banks. They tended to view bank failures as 'regrettable consequences of bad management and bad banking practices'. They were also 'beholden' to the Gold Standard because it was considered to be the ultimate bulwark against inflation.

The Fed of 2007 and 2008 overestimated the inflation risks too, with tragic consequences for millions who would lose their jobs and homes. The Fed was not alone. The Bank of England and the European Central Bank also failed to comprehend the true threat facing the world economy.

Superficially, it did appear as if the policymakers had a point. By March 2008, inflation had risen to 4.0 per cent in the US, 2.4 per cent in the UK and 3.5 per cent in Euroland. Oil and food prices were soaring. Over the summer, inflation would climb to a high of 5.6 per cent in the US. It would more than double in the UK, rising to 5.2 per cent by September. And in Euroland, it would accelerate to more than twice the European Central Bank's target, jumping to 4.1 per cent by July.

The debate over runaway commodity prices was polarised. Some saw this as a manifestation of loose monetary policies in the West and particularly emerging market economies. Central banks in the West would have to hike interest rates further, it was claimed, to compensate for the unwillingness of policymakers to tame a surge in inflation across emerging market economies. Across Eastern Europe, Asia, Latin America, the Middle East and Africa, inflation was accelerating, climbing well into double digits in many countries.

Some economists highlighted the specific supply problems that had contributed to big cost increases. Peak Oil, the growth of biofuels and climate change were held responsible for the surge in energy and food costs. However, metals and other non-food and energy commodity prices were also rising sharply in response to strong emerging market demand.

But the longer-term or secular threat to inflation was far from clear-cut. Much of the rapid growth in emerging market demand reflected domestic credit bubbles that in many cases were more extreme than in the West. When they burst, demand for commodities would collapse taking prices down swiftly.

And so it proved. Having more than doubled in three years, base metal prices finally...