Beware - our sins may return to haunt us

This article was first published on the Telegraph on 6 August 2009

The year is 2010. The Tories have won the general election and the stage is set for the long road to recovery. As David Cameron and George Osborne huddle in Downing Street, an adviser enters with baleful news. One of the country’s few remaining banks is hours from collapse; others threaten to fall in its wake. The financial crisis has returned.

That, at least, is the scare story doing the rounds in the City these days. On the face of it, it seems far-fetched: after all, the economy and financial sector have staged an unexpected recovery in recent months and, unlike many previous jumps, this one does look and sound pretty genuine.

The housing market is starting to fizz again. It isn’t merely that prices are rising – which they are. Activity is increasing; people are putting their homes back on the market; properties are selling for more than their offer price. The Royal Institution of Chartered Surveyors, having predicted at the start of the year that prices would tumble by as much 15 per cent, now thinks house prices may end 2009 higher than they started.

The wider economy, too, is back on its feet again. Both the services sector, which accounts for three quarters of Britain’s economic output, and the manufacturing sector, which makes up much of the rest, are growing again for the first time in more than a year. Moreover, industrial production figures released yesterday suggest that those dreadful gross domestic product figures last month, which showed that the economy shrank by an unexpected 0.8 per cent in the second three months of the year, probably overestimated the fall.

And towering over everything else is the stock market. Shares in London have been rising predictably since early July, as have those in Wall Street, where the benchmark S&P 500 index recently surpassed the key 1,000-point mark for the first time since the collapse of Lehman Brothers. To dismiss this evidence as meaningless would be foolish: it is genuinely encouraging. Even if the rises prove to be short-lived, they show that, at the very least, the massive dose of economic medicine pumped into the economy since last year, in terms of interest rate cuts, tax reductions and bank rescue money, is having some effect, and that for all the doom and gloom that has surrounded Western economics, there are also precious slivers of optimism.

But such effects are largely a consequence of the current combination of record low interest rates and temporarily lower VAT. They disguise the fact that next year is likely to bring two even bigger threats. The first is that of sovereign default. Almost every major economy has borrowed so much that they may struggle next year to find anyone willing to take on their debt for a reasonable price. This underlines why the Conservatives, should they win the election, will have little choice but to call an emergency Budget to impose austerity measures on the state and safeguard Britain’s solvency.

The second concerns the apocalyptic tale of a second financial crisis. While there is much to support the view that the banking system is safer than it was 12 months ago – the Government having pumped hundreds of billions into its foundations to ensure its survival – these emergency buttresses were designed to protect us against the collapse of the American housing bubble. But here in the UK we have our own housing slump to worry about.

The combination of rising interest rates (likely) and unemployment (certain) will push up the number of home owners who default on their mortgages. Indeed, according to research group Fathom Consulting, the number in arrears is likely to outdo the peak of the last housing crash. Some of the Bank of England’s own figures indicate that these losses could stretch to as much as pounds 400 billion – four times what the banks have so far raised in emergency capital from the Government.

This is no new worry – it is something the International Monetary Fund warned about in its recent report into the UK – but amid the rising tide of good news, it appears to have been swept under the carpet.

Tucked away in the results from various banks this week, there was a hint of the pain to come. While the investment banking arms of Barclays and HSBC raked in record profits, their domestic arms – and those of Northern Rock and Lloyds (and newly bought HBOS) – did rather appallingly. The fact is that they are being haunted by their imprudent lending to UK households and businesses.

Notwithstanding the economic shafts of light in recent weeks, people are still suffering. Every week, tens of thousands more people lose their jobs. As their savings run dry, they struggle to hang onto their homes. Banks, themselves still trying to repair their balance sheets, are less willing to lend, even to those with the ability to pay them back.

Given that this is happening now, with interest rates at half a percentage point, one can hardly bear to imagine how tough it will be when, at some point in the next couple of years, borrowing costs have to rise again. There are two possible outcomes: either the companies will have to be bailed out by their shareholders or the Government, or they will have to make up the difference by charging customers yet more. The credit crunch has many months – or, more likely, years – to run yet.