America was conned - who will pay?

The South Sea Bubble ended in riots as trust was lost. Wall Street also duped the public

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By Larry Elliott

Bear Stearns marks the moment when the global financial crisis went critical. Up until last Friday, it had been possible - just about - to believe that the worst was over and that things were about to get better. That pretence was stripped away when JP Morgan, at the behest of the Federal Reserve, stepped in when the hedge funds pulled the plug on the fifth-biggest US investment bank.

It is now clear that no end is in sight to the turmoil, and the reason for that is that the Fed and the US treasury are no closer to solving the underlying problem than they were eight months ago. The crisis will only end when house prices stop falling and banks stop racking up huge losses on their loans. Doing that, however, will require the US government to intervene directly in the real estate market to end the wave of foreclosures. Ideologically, it is ill-equipped to take that step and, as a result, property prices will fall and the financial meltdown will go on and on.

Ultimately, though, action will be taken because there will be political pressure for it. Indeed, it is somewhat surprising that there is not already rioting in the streets, given the gigantic fraud perpetrated by the financial elite at the expense of ordinary Americans.

The US has just had its weakest period of expansion since the 1950s. Consumption growth has been poor. Investment growth has been modest. Exports have been sluggish. But if you are at the top of the tree, the years since the last recession in 2001 has been a veritable golden age. Salaries for executives have rocketed and profits have soared, because the productivity gains from a growing economy have been disproportionately skewed towards capital.

Patriotic

For ordinary Americans, though, it has been a different story. Real wages have been growing slowly; at just 1.6% a year on average over the latest upswing, well down on the experience of earlier decades. Business, of course, needs consumers to carry on spending in order to make money, so a way had to be found to persuade households to do their patriotic duty. The method chosen was simple. Whip up a colossal housing bubble, convince consumers that it makes sense to borrow money against the rising value of their homes to supplement their meagre real wage growth and watch the profits roll in.

As they did - for a while. Now it's payback time and the mood could get very ugly. Americans, to put it bluntly, have been conned. They have been duped by a bunch of serpent-tongued hucksters who packed up the wagon and made it across the county line before a lynch mob could be formed.

The debate now is not about whether the US is in recession but how deep and long that recession will be. Super-bears have started to say that this is perhaps "The Big One", by which they mean the onset of a new Great Depression. The need to rescue Bear Stearns has done little to still those voices.

As the economics team at HSBC recently pointed out, there has been a "catastrophic breakdown" of trust, and when that has happened in the past - the US in the 1930s, Japan in the 1990s - chucking extra money at the banks in the hope that they will start lending again proves ineffective.

It's not hard to see why trust has become such a rare commodity: Wall Street at the height of the securitisation mania had, in effect, become London at the time of the South Sea Bubble crisis in 1720. Vast quantities of funny paper were changing hands even though those involved in the deals had no idea of their true worth. Nor did they care. Inevitably, now the bubble has burst and the huge Ponzi securitisation scam has been exposed, there has been a reaction. The securitisation market is dead, there is less money sloshing round the system, banks are hoarding their cash.

Having allowed the housing boom to rage out of control for too long and then delaying cuts in interest rates until the housing market was gripped by recessionary forces, the Fed is now trying to make up for lost time with a burst of hyperactivity. It will cut interest rates on Wednesday and keep cutting them: financial markets expect the Fed funds rate to be 1% by the summer, and they are probably right. In most downturns, easier monetary policy does the trick. Lower interest rates make it cheaper to borrow and also change the trade-off between saving and spending. This may not be the usual sort of downturn, however, with consumers going through a period of debt revulsion after the excesses of recent years, even so the consensus is that after two or three quarters of falling output, a slow and sluggish recovery will be under way.

Deflation

These hopes are likely to be dashed, unless there is intervention at home and internationally to tackle the crisis. Domestically, the priority should be to stop homes that have been foreclosed being auctioned on the open market, since by selling them at a 50% discount property prices are driven down. The US does not seem to have learned the lessons from Japan, which encouraged a fire sale of property in the 1990s and was sucked into a classic debt deflation trap as a result. Those who argue, with some force, that it would be counter-productive to intervene in the market because the US needs to work the rottenness out of its system must recognise that the cold turkey option will be very long and painful.

The second form of intervention should be to shore up the dollar, the collapse of which is worrying countries that rely heavily on exports and is the main reason for the surge in commodity prices. Co-ordinated intervention by the major central banks needs to be at the top of the agenda at next month's G7 meeting in Washington, and there could be action even sooner if the dollar continues to tank.

In the longer term, lessons must be learnt from the turmoil. One is that you don't solve the problems of a collapsing bubble by blowing up another, which is what Alan Greenspan did after the dotcom fiasco in 2001 - the most irresponsible behaviour of any central banker in living memory.

The second lesson is that there has to be far stricter regulation not just of the US real estate market but of Wall Street, to prevent the return of irresponsible lending as soon as the recovery is firmly under way. If this is, heaven help us, The Big One, one of the only consolations will be that the repugnance at the orgy of speculation that has sapped the strength of the US economy will put a new New Deal on the political agenda.

But for this to happen there has to be a political response and even though this year's presidential election will be held in the shadow of recession, there appears not to be a potential FDR among the contenders for the White House. Yet if this crisis really does get as bad as some are forecasting, the public will rightly demand more than a slap on the wrist for Wall Street.