Monster haunts world economy

This week I am escaping the heat of the Gulf in Inverness, Scotland and have just been on a trip around Loch Ness to find the fabled monster. However, the only monsters that are in evidence in The Highlands this year are the global financial crisis, the derivative time-bomb and inflation.

For the rising cost of fuel has dissuaded English motorists from heading north of the border this year and Inverness is decidedly quiet. It says something for contagion in the global economy that a downturn can spread to such a distant corner of the United Kingdom so quickly.

Lest we forget the downturn that started in US housing a little over two years ago has turned so-called sub-prime mortgages into write-offs for financial institutions around the world which bought these securitised assets. The over-valued British housing market has also crashed with prices now falling at their fastest rate ever and another round of huge provisions loom for the banks as these loans go bad.

Higher energy prices have helped to drive inflation upwards crimping consumer spending, and one way to save money on fuel is to travel less far.

A recent article in Business Week explained how the US overspent from 2000 through to 2007, with $92.5 trillion worth of goods and services produced compared with purchases valued at $97trn, a $5.5trn gap that had to be financed. Consumer debt, mainly financed against housing, paid for this deficit and rose by $6.8trn. In the process, personal consumption jumped from 67 to a record 72 per cent by 2007.

This new credit has come almost entirely from the shadow banking system of the hedge funds, investment banks and their derivative products. And it is this derivative time-bomb that is now a monster that threatens the global economy. It is even menacing tourism to the home of the Loch Ness monster.

The scale of this problem is truly awesome. Business Week cites the $250 billion of securities in Merrill Lynch's trading portfolio of which only 30 per cent could be priced to market.

If this sounds like a bit like the story of Nick Leeson, the man who broke Barings Bank in the mid-90s by racking up huge hidden losses then this is only too true, except that this picture is repeated in a series of major global financial institutions. Will they all be bailed out, forced to merge or allowed to go under?

None of these options is without a cost. A bail-out on a huge scale will mean a dollar crisis with further devaluation. Forced mergers mean downsizing and huge write-offs; and allowing firms to fail risks the financial system collapsing like a house of cards due to third party risk.

The $800bn upper limit set for the bail out of the US mortgage guarantee agencies Freddie Mac and Fannie Mae gives little reason for comfort. This kind of dollar printing just has to be highly inflationary, and the moral hazard of bailing out bankrupt financial institutions encourages more bad practice. Yet this is exactly where the US authorities seem to be taking the global economy. This is a highly inflationary policy path.

There will also be a reaction that restricts and hampers credit flow and the unregulated derivatives market. This is what should have been done years ago to stop the US economy becoming overleveraged and in the process overvaluing many asset classes, most notably real estate. But it is going to be a long and messy process, and will keep asset prices depressed.

As this column has argued on many occasions the true culprit in explaining high energy prices is the over-expansion of the global economy through easy money provided by too low US interest rates. Oil prices have tripled in the past year just as they did in 1973. That set the 1970s off on its destructive period of high energy prices and soaring inflation. I do not see any reason why it should be different this time, except that official measures of inflation have become ludicrous and highly inaccurate. That unfortunately will delay necessary policy changes as governments continue to argue that obviously high inflation does not in fact exist.

The monster of inflation is back and even menacing the tourist industry of Loch Ness this summer. Only for Gulf residents is there some comfort in remembering that the late 1970s were a boom time for the region and unsurpassed until the current day. High oil prices could well persist under this scenario of global gloom, supported by the ongoing bail-out of the US financial system.