In the chaos economy, one man's debt is the whole world's burden

First published in the Telegraph on 14 September 2007

Globalisation is eating itself. The past few weeks have seen the world’s financial system turn itself upside down. Not so long ago it was the bankers who decided the fate of the lowliest in society. Now, in a bizarre reversal of fortunes, it is America’s poorest who hold the fate of Wall Street and the City’s richest financiers in their hands.

All around the Square Mile bankers are being laid off, bonuses have been obliterated and expenses bills are being slashed. Michelin-star restaurants are off-limits; Beluga on blinis is a no-no; bottles of vintage Petrus likewise. First-class flights are now verboten and the mood is miserable – not only because the masters of the universe have been relegated to cattle class.

Billions of pounds are being lost in financial markets and the extent and depth of the recent crisis is still taking everyone by surprise.

Most galling of all is the fact that the very people responsible are the smallest of all the cogs in the financial system – the cash-strapped families taking their first steps on the housing ladder. Millions of new homeowners in America are at, or close to, default – meaning major losses for those who lent them the cash. The result is a financial mess.

It might have read like a cautionary moral tale about greed and excess if it weren’t for the fact that we’re all in this boat together. Northern Rock’s dramatic decision to go cap in hand for cash to the Bank of England shows the crunch is also hitting the institutions which hold millions of pounds of UK household savings. Nor is it just this bank’s customers who may be affected.

The credit crunch facing markets now looks like turning into a Christmas crunch for all of us. Slowly but surely, the raw misery dished out by American homeowners to the banks is being sliced and diced and served right up to the British public.

Despite rumours to the contrary, it’s actually pretty easy to understand what’s going wrong here: the sense of fear pervading the financial markets at the moment means banks are scared to lend to each other. This pushes up their borrowing costs and they are now, in turn, passing on these extra costs to homeowners – in the shape of higher mortgage rates.

This is an economic landmark – it is the first time banks have changed a swath of their mortgage rates because of what has been going on in the markets rather than because of a change in the Bank of England’s base rate. Northern Rock is suffering in particular because it is most reliant on money borrowed from its fellow banks.

Welcome to the 21st-century chaos economy – the butterfly’s wing-beats in one tiny, unknown part of the financial world that cause a hurricane in another. Like it or not, no one can choose to ignore economics any more.

This doesn’t mean we should all be reaching for the macro textbooks. But it does mean we can no longer take it for granted that our finances will be affected only by the kinds of things we traditionally took notice of: our salaries, UK inflation and interest rates. In the old days, economic slowdowns were caused by familiar domestic issues such as unemployment, inflation and so on.

These days, it is an entirely different story. Of course these factors are still vitally important, but not just on these shores – or, for that matter, in the US or Europe.

There are two reasons: first, the fall of the Berlin Wall and the end of the Cold War, which created a truly global marketplace; second, the sophistication of today’s capital markets makes it easy for debts to be spread far and wide.

Previously, mortgage cash really was lent out by a bank directly to its customer, with the business suffering if the borrower defaulted. Today, the mortgage is more likely to have been sliced up into little pieces, packaged away and sold on to investors far away, who behave like a bank and lend out the cash, hoping for a steady return.

This has meant that the world economy’s eggs are not in one basket, but scattered all over the place. As you can probably guess, though, the upshot is that when problems do occur, everyone is left suffering.

As ever, attention now turns to the hunt for someone to blame. Is the culprit Alan Greenspan, the revered former chairman of the US Federal Reserve, who pulled down interest rates to almost unprecedented lows a few years ago, fuelling the debt binge across the world?

How about the dodgy lenders in America, who somehow handed out mortgages to people without an income, a job or assets? Then there are the rocket scientists and mathematicians employed by banks to create complex packages, filled with minced mortgage debts from around the world, and sold on to investors without an instruction manual. Or the credit-rating agencies that implied investors didn’t need manuals since they could vouch for the quality of these little Pandora’s boxes of debt.

All of them must share the blame to some degree, although the latter two are most likely to take the rap.

Alistair Darling implied in an interview in this newspaper yesterday that he may clamp down on the banks for lending recklessly. The chances are he will go too far. History shows that in the wake of a crisis governments impose gratuitous regulations so as to be seen to be doing something – anything.

So let’s not forget that although their name has been dragged through the mud, sub-prime mortgages – the ones lent to the poor households that have been at the heart of this crisis – are not, per se, a bad thing. On the contrary, both in the US and Britain the creation of home loans for families with poor credit records has, for the first time in history, enabled many to mount the property ladder who would not otherwise have been able to afford it. The worry is that the entire sub-prime sector will be among the victims of the forthcoming tide of new rules. This would be a tragedy.

It would be wiser to let the market deal with this problem itself. For the most part, those who are losing money now are banks and investors who foolishly bought up risky debt packages at unnecessarily high prices. Capitalism is often nasty and messy, and people lose cash as well as making it. The Bank of England has shone out as the one central bank willing to tell banks it will not bail them out because of their own incompetence. It is only helping Northern Rock because it believes its problems will be short-lived, and are genuinely beyond its control.

Meanwhile, the financial system may be bruised but it is not close to collapse. The market turmoil will not have made life any easier for homeowners around the UK, but it has not had a serious impact on their finances – yet.

By Tuesday night we will have an idea of whether the crisis will last much longer. The Federal Reserve is due to decide on US interest rates then. If it does anything less than cut rates by half a percentage point, markets will take an even deeper tumble.

It may be only one financial decision in a country far away, but only a fool would ignore it now.