Feature Article

Decline and fall

The current ‘credit crunch' may not be the economic disaster of the Great Depression. But the cover of the global banking system and the reputation of Britain's ‘prudent' prime minister and former chancellor have been blown and will be difficult to repair

Many a true word is spoken in jest. Gordon Brown's favourite joke used to be: "There are two kinds of chancellor: those who fail and those who get out in time." In one sense our present prime minister and former chancellor certainly did get out in time. There are time lags in the formation of reputations as well as in the workings of the economy, and in June 2007, Brown moved from 11 Downing Street to Number 10 with his reputation for economic competence largely intact.

It was true that some observers were concerned about the balance of payments deficit, about the way that a period of rapid economic growth had not been used to reduce the budget deficit, and about an excessive reliance on consumer debt to boost what economists call "consumer spending" (that is, spending by you and me). True, also, some analysts were especially concerned about the way that house prices seemed to be spiralling ever upwards, the emphasis being on "seemed", because history suggested that at some stage there would be a reaction. Nevertheless, while the fragility of certain economic trends can be diagnosed by those with a sense of history, the timing of the onset of a reaction is notoriously difficult to forecast.

Last June, Brown still largely retained his reputation for having, if not eliminated, at least brought under control the British economy's traditional propensity for what he called cycles of "boom and bust". Meanwhile, prominent economists who had for several years been predicting a collapse in the housing market were being dismissed as Jeremiahs.

Today, the landscape looks remarkably different. It was suddenly last summer that the clouds began to appear. In August came the first news of banks in difficulties; then came the American "sub-prime crisis" and the fiasco of Northern Rock. As summer gave way to autumn, the economic mists began to settle, unaccompanied by mellow fruitfulness. The phrase "credit crunch" appeared in the financial pages; and soon after it was no longer confined to the business section.

The joke in the Treasury has been that it is the job of Brown's chosen successor as chancellor, Alistair Darling, to take the flak. But, because Brown moved upwards, to the top job, he himself is not protected by his fellow Scot's flak jacket. The storm cones now being hoisted over the economy worry him as much as they worry Darling, and they happen to be hoisted at a time when the prime minister has been the object of considerable criticism over many other aspects of policy, not just the economy.

But it was on a successful economic stewardship that our Son of the Manse placed his bets, and it is on the outcome of the current economic crisis that his reputation with the voters will ultimately depend. For there is no getting away from the fact that this is an economic crisis. The big questions are how serious it is and how prolonged it will be.

Having made ill-advised boasts about the putative superiority of the British economic model over that of, for example, the Eurozone, the Government is now tending to claim that what we face is essentially an imported crisis, but that its hitherto responsible stewardship places it in a reasonable position to weather the storm. However, the crisis is not entirely imported: the American sub-prime crisis - the repercussions of the discovery that too many rash loans were made by bankers and mortgage companies to borrowers who were incapable of sustaining the burden of servicing or repaying - may have been the proximate cause of the credit crunch, which has almost paralysed large segments of the banking system. But, as the International Monetary Fund has pointed out, quite irrespective of events in the United States, the British property market was grossly overvalued already.

Curiously enough, while trying to calm nerves and maintain that Britain, thanks to Mr Brown's stewardship, is better placed than some (a view which is hotly disputed by many independent analysts), Alistair Darling has also been fomenting fear by describing this as "the biggest economic shock since the Great Depression". This is an extraordinary thing to say. The IMF has already suggested that it may be the biggest financial shock since those days - it is quite something when banks are so suspicious of one another, and so reluctant to lend. Indeed, the entire banking system is in disgrace, as so many of its exotic "financial products" prove to be either worthless or not worth very much. But there is a big difference between the position now, when output may be falling by a few per cent, but is widely forecast to recover in the second half of the year, and the Great Depression itself, when output in the US fell by a third - yes, a third - between 1929 and 1932.

Both the Second World War and the oil crises of the middle and late 1970s produced bigger economic shocks than we have experienced during the current crisis - at least so far. The problem is that things may get an awful lot worse. The good news is that policymakers have learnt something from the mistakes of their forefathers in the Great Depression, and are doing their best: the US has cut interest rates dramatically, and is introducing big tax cuts in the second half of the year. But the bad news is that if the financial crisis is not swiftly resolved, and if banks suffer prolonged difficulty in restoring their badly bruised balance sheets, then the financial crisis could indeed evolve into a much greater economic crisis than we have seen so far.

But if the use of the word "depression" is over the top, there is no getting away from the prospect of hard times ahead. Both bankers and consumers have been living in a fantasy world, in which property (with its rising values) was regarded as a kind of everlasting cash machine, and bankers forgot the principles of old-fashioned banking - know your customers, have a reliable source of deposits, keep sound liquidity and reserve ratios. The cover of the financial system has been blown, and will take some replacing. These are rough times for the economy, for those who have borrowed excessively or imprudently, and for the reputation of the chancellor/prime minister who professed his prudence. Whether they bear comparison with the Great Depression is another matter.