A fate worse than debt

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: demand will cause businesses to shed jobs, creating further falls in demand and more bad debts.

Once started, the process is hard to stop. “What the financial and household sectors are doing is unwinding more than ten years of a credit boom,” says George Magnus, an economist at UBS. “The idea that they can rid themselves of this problem in a matter of months is pie in the sky.”

Then there are businesses. Thanks to strong recent profits, many firms are less geared than they were earlier this decade during the telecoms bust. Nevertheless, there are plenty of big borrowers around, including carmakers and businesses bought by private-equity groups. They may struggle to refinance their debts as they fall due. Martin Fridson, of Fridson Investment Advisors, says that the default rate on high-yield bonds may climb to 10%.

Even firms that are not heavily in debt may think twice about expanding. According to Morgan Stanley, changes in bankers’ attitudes to lending tend to lead business investment by three quarters. If the past pattern holds good, by the summer of next year investment may be falling at an annual rate of more than 10%. That will further depress economic growth.

The danger is of a “second-round effect”, as the crisis in finance affects the economy, leading to further problems in finance. Mortgages may be the problem asset of the moment but next year the worry may be about credit cards, car loans and corporate debt.

The Bush administration’s rescue plan aims to arrest this deleveraging cycle. But it will not be easy. “Eventually they will put the fire out,” says Nick Carn, a partner at Odey Asset Management, a hedge fund. “The question is how much gets burned between now and then.”