Are we about to pay the real price of having cheaper credit?

THE world economy has been floating on a sea of cheap credit for much of the present decade.

The recent sharp falls on global stock exchanges have marked the moment when the financial markets realised this era is coming to an end.

Cheap credit depended, in the first place, on the actions of the central banks of the leading capitalist states. In 2000/1, faced with recession in the US and then the September 11 attacks, the US Federal Reserve Board slashed interest rates to the bone.

Speculation migrated from the stock market to housing. Low interest rates made for cheaper mortgages and boosted house prices. Home owners could borrow on the strength of their higher property values.

Investment banks, hedge funds and the like squeezed profits from all this cheap credit. They developed the sub-prime mortgage market. This loaned money to poor people with bad credit records who had to pay over the odds for their mortgages.

Credit is being created on a gigantic scale by hedge funds and the like pumping money into the economy. If this non-bank funded liquidity dries up, there is a credit shock with real economic implications.

This is what is happening now. The 'credit shock' started when the central banks began raising interest rates. They were worried about rising inflation.

The Bank of England and, more hesitantly, the Federal Reserve decided to make credit more expensive in the hope of slowing the economy.

Despite the Federal Reserve's caution, the interest rate hike was enough to cause the collapse of the sub-prime market last spring. The US housing market and construction industry went into recession.

Then Wall Street investment bank Bear Stearns admitted two of its hedge funds in the sub-prime market were effectively worthless.

But the important question is whether the sudden seizing up of the speculation machine will spread to the real economy and push it into recession.

JOHN SMITHEE

Kingsley Avenue

Wisbech