Overview

Andrew Smith, Economist, KPMG LLP (UK)
Commentary April 2008

The economy and the credit crisis – can the phoney war last much longer?
Outside the United States, which is teetering on the edge of recession, there is little hard evidence that the credit crisis is having a significant impact on the real economy. In the UK, for example, GDP growth in the fourth quarter last year was still close to its trend rate and so far this year the trend in retail sales has remained positive, if volatile, suggesting that the consumer is reluctant to play dead. In Germany, the resilience of the industrial production/export growth engine continues to surprise.

However, this does not mean there will not be effects, possibly severe ones. Economies tend to react to changes in the financial markets only after a lag as economic agents are slow to adjust their plans in the hope that any disruptions are temporary. But, if not, this cannot continue indefinitely and there are ominous signs that the current phoney war may not last much longer.

There are three main routes by which the financial markets can affect the real economy – credit conditions, wealth effects and confidence. And there is little doubt that credit conditions are tightening. Despite cuts in official interest rates in the US and the UK, interest rates in the money markets – off which commercial loans are priced - remain obstinately high. Additionally, lenders are expanding their margins, further pushing up the cost of loans. And they are tightening their lending criteria, effectively rationing credit. The lower interest rate medicine prescribed by the central banks is not getting through to the patient.

Wealth effects are less certain but in the same way that people feel better off and spend more when asset prices, particularly house and share prices, are rising, they feel worse off and wish to spend less when asset prices are falling. Equity prices are currently down only some 10-15% and may not be having that much of an effect, but in the US declining house prices seem to be having more of an impact (as well as further undermining the value of those notorious sub-prime loans). Other economies vulnerable to deteriorating housing markets include the UK, Ireland and Spain.

The economist, John Maynard Keynes, talked about confidence hanging by a gossamer thread. Clearly it snapped in the credit markets some time ago and surveys suggest that, as far as the consumer is concerned, it is close to breaking point. In the US, not surprisingly, sentiment is plumbing depths last seen at the time of the Gulf War; more surprisingly it has also plummeted in continental Europe and the UK, even though unemployment has continued to fall and employment has continued to increase.

These depressing factors are difficult to quantify and against them must be set attempts at off-setting action by the authorities, not only in terms of interest rates but also the huge injections of liquidity, the support for banks perceived to be at risk and, in the US, a fiscal response in the form of tax rebates coming this summer.

However, if the root of the crisis is the build up of under-priced debt and over-priced assets in preceding years, the best the authorities can hope for is to manage the process of de-leveraging and asset price deflation without a nasty accident. They cannot prevent the process having economic repercussions. 

April 2008.

Back 

		The KPMG Difference View Our Latest Press Releases KPMG News Feed See Our Most Recent Publications See the Awards We Have Won Office & Phone Listing

		KPMG UK 2006 Annual Report ( PDF 1382 KB)

		New & Emerging Markets Supporting you in China, India, Russia, Brazil, Korea and Vietnam VIEW>