What started as a credit crunch and financial downturn in 2007/08 has developed into a G7 economic recession. The feedback loops between the financial system and real economy have proved far more powerful and 'contractionary' than most forecasters predicted.
The UK's recession has been deepened by the high level of consumer and corporate debt in the economy, and the fall in house prices. Government sponsored support and re-capitalisation schemes for the financial system, which were first announced in 2008, have proved inadequate as the scale of bank balance sheet impairment has dwarfed the early schemes and banks have been left with toxic assets on their balance sheets.
The uncertain scale of the losses on toxic assets, many of which are tied in value to the US housing market, has meant that UK banks have been hoarding cash, both because they have been reluctant to lend to other banks, and in order to meet capital ratios. This cash stockpiling, alongside reduced lending to households and corporates, has increased corporate defaults and housing repossessions, causing further deterioration in bank balance sheets.
To date, UK Government schemes and record low base rates (1%) have not broken the vicious spiral downwards in activity and lending. In the US, Treasury-led bank support schemes and a reduction in short interest rates to zero have not succeeded either in preventing a deepening recession. Both the UK and US economies recently reported annualised contraction of about 5% in the fourth quarter.
Key to this year, for the UK, is the financial system's state of health. If it remains dysfunctional, it is hard to see the economy recovering significantly in 2009, since higher unemployment and lower house prices are likely. However, some stabilisation in the financial system and associated improvement in confidence may restrict the decline in consumer spending.
Unfortunately, even in an optimistic scenario, the recession looks likely to be at least as long as the 1990-1992 version of six to eight quarters (the economy has now been contracting for four quarters).
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