A Nightmare on Wall Street

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: Like a Hollywood monster that is impervious to bullets, the credit crisis refuses to lie down and die. The authorities have bombarded it with interest-rate reductions, tax cuts, special liquidity schemes and bank bail-outs, but still the creature lumbers forward, threatening new victims with every step. Global stockmarkets are suffering double-digit losses this year, and credit markets are once again gummed up.

For investors who cut their teeth in the 1980s and 1990s, the persistence of the crisis must be a surprise. Prompt action by central banks, after Black Monday in 1987 (when America’s stockmarket fell by almost 23%), or following the collapse of Long-Term Capital Management, a hedge fund, in 1998, suggested it was always worthwhile to “buy on the dips”.

One reason why things are different this time is that there has been a double shock. On top of the decline in house prices and the associated drop in the prices of asset-backed securities, the markets have also had to face a surge in commodity prices. That has constrained central banks from easing monetary policy as much as they might have done, particularly in Britain and the euro zone. Even in America, rates might now perhaps be 1% (as they were in 2003) without the commodity boom.

In addition, the combination of the two shocks has created uncertainty about the direction of monetary and regulatory policy. Will the central banks be forced to “do a Turkey” and adjust their inflation targets upward (implicitly or explicitly) to reflect reality? Alternatively, will they crack down so hard on inflation that they force their economies into recession? And will the price of investment-bank rescues be a harsh new regulatory regime that restricts the scope for future credit (and economic) growth? In the face of all this uncertainty, investors can hardly be blamed for being cautious.

The way that the crisis has centred on the banking industry also explains its duration. Stephen King, an economist at HSBC, points out that the financial crises of the 1990s were also prolonged, from the savings and loan collapses in America through the Swedish banking rescues to the extremes of Japan’s debt deflation. As Mr King says, “if banks are unable or unwilling to lend, monetary policy doesn’t work so well.”