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Hamish McRae: Don't believe everything George Soros says

Wednesday, 21 May 2008

If George Soros thinks Britain is likely to have a recession, it must be so? Er, no. The Hungarian-born billionaire speculator and philanthropist made his name, and much of his fortune, by betting against sterling ahead of its ejection from the ERM in 1992. That earned him the sobriquet: "The man who broke the Bank of England" and a place on the Forbes rich list. He is big bucks, though not the biggest, since at $8.5bn last year he came in at only No. 80 in the ranks of global billionaires.

Still, that plus his hugely successful books is enough to make people sit up. And so it was yesterday when he was interviewed on the Today programme. We were, he said, past the "acute phase" of the credit crunch but he added: "Financial institutions have been severely damaged and we are currently in a situation that will probably, I think almost inevitably, result in a recession certainly in the United States and most likely in England also."

Since this comes on top of a warning that the world faces the most serious financial situation since the 1930s, it is all a bit daunting. Add in the warning last week from the governor of the Bank of England, Mervyn King, that the UK faced the possibility of recession, though that was not the Bank's central forecast, and we now have both a chief gamekeeper of financial markets and a most successful poacher leaning towards similar judgements.

So should we be scared? Or should we grasp Franklin D. Roosevelt's wonderful phrase in his first inaugural address in 1933: "The only thing we have to fear is fear itself", and lighten up?

I think at a time like this it is important to be measured. This is not unknown territory. We have a lot of experience of post-war economic cycles and you have to be profoundly gloomy to believe that this one will be outside the boundaries that these define. I would go further: you have to be profoundly gloomy to believe that the next few years will be as bad as the 1970s, in economic terms the most difficult of the post-war decades. Then there was double-digit inflation and a double-dip recession in most developed countries, followed in the 1980s by double-digit unemployment in many of them as inflation was slowly ground out of the system.

So what can we say? George Soros makes a good distinction between the acute phase of the credit crunch and its economic consequences. However you want to attribute the blame for the banking difficulties of the past nine months it does seem pretty self-evident that this acute phase is past. You always look to a major banking institution needing to be rescued to signal the turning point. Northern Rock wasn't big enough; nor were the regional German banks. Besides, they were in the wrong country. The crisis originated in the US and it was there that the collapse had to occur. But Bear, Stearns, in New York, signalled the turning point. The convalescence of the world's banks has begun.

This will take time. Banks are going to spend the next two or three years recovering their financial positions but they will be cautious for a decade or more. They know they will face stricter regulation, for that will be the price for the public support they have received. But of course if they are regulated more strictly they will be able to lend less freely. So there will be a balancing act, you could almost say a test of wills. The regulators can do whatever they feel fit, but the banks will respond – will be forced to respond – by cutting the scale of their activities. Put brutally, the tighter the regulation, the stricter the terms on new home loans.

So the question is the extent to which this new caution in the financial institutions will feed though into the real economy. There are various transfer mechanisms, of which the housing market is the most obvious. This is not just a British and American matter, for most of the developed world (the principal exceptions are Germany and Japan) has experienced some sort of housing bubble. These will take some time to subside. While these adjustments occur there will be a steady downward pressure on consumer demand, and since consumption accounts for 60-70 per cent of GDP in most developed countries that in turn leads to slower overall growth.

But slower growth is not recession. Recession is when an economy shrinks, in that curious expression experiences "negative growth". Only economists, you might say, can manage to contradict themselves in a two-word phrase. Anyway it takes six months, or two consecutive quarters as economists put it, of negative growth to constitute a recession.

Were the problems just in banking and the housing market, there would have been a good chance of the main economies scrambling though this cycle without recession, certainly without a serious one. What has changed matters, indeed made this downswing quite different to any previous one, has been the shift of economic power to Asia.

This has had two effects. One is that overall global demand will remain higher than in previous cycles, with China last year adding more demand to the world than the US for the first time for at least a century. The other new effect is the consequence of that. During this downswing there will not be the usual easing of inflationary pressures, or at least not as marked a decline as you might expect. So we are going into a downswing with oil at nearly $130 a barrel and the prospect of inflation here, in the US and in Europe rising for another year, maybe more.

That will squeeze our living standards. Money spent on filling the car is money not available to spend on something else. In previous downswings unemployment took the brunt on the strain as the economies slowed. If you were fortunate enough to keep your job you were probably all right. This time it looks as though unemployment may rise a little but to nothing like the early 1980s or early 1990s. Instead it will be the living standards of most of us, those in jobs and those who have retired that will take the strain.

In one sense this is welcome: much better that we should all feel some burden of adjustment rather than have this burden carried disproportionately by the unemployed. But actually there will still be a big random element. People in the public sector will be better protected than in the private; pensioners with indexed pensions will do particularly well. Conversely those who have borrowed heavily will be under pressure.

There is also a political element here. Widely spread pain means widely spread dissatisfaction with the government. A better economic outturn may be a worse political one.

All this is predicated on the notion that Mervyn King's judgement – the possibility of recession, not the probability – will prove more accurate than George Soros's one: that recession is "most likely". One may be a better speculator but the other is a better economist. But even if Mr Soros does prove right I don't think we should jump out of windows. A shallow recession, with the pressure widely spread, is not a catastrophe.

Agree? Well you can listen to him on the web when he is talking at the London School of Economics tonight. The man who broke the Bank of England? Sure, but it was that devaluation in 1992 that ushered in the new monetary control arrangements at the Bank, and also led to the longest expansion the British economy has ever experienced. Actually he did us a good turn.

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I dont believe Soros urged anyone to jump out of windows. UK debt compared to income is astronomic in historical terms. This was OK in the NICE decade - not any more.

As a clever economist, Nouriel Roubini, pointed out, financial institutions cannot rely on securitised debt fuel to motor the world economy anymore. So there will be massive deleveraging irrespective of where LIBOR is and what credit spreads are. That will impair banks' ability to generate profits as well as reduce the loan amounts available. The most affected economies will be those most in debt. That is why UK plc is stuffed.

Posted by onion | 21.05.08, 07:17 GMT

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I'm with George !!Both the US and UK went on crazy debt binges fuelled by cheap debt and non existent regulation. Now the credit cycle has peaked and is contracting the consumer will pull back. Couple that with inflation on the march I don't think the consumer can spend much more !!Back in the UK in Jan an old friend of mine in Real Estate ( who's been through the early 80's market and the 90's dump ) said he'd never seen it so bad - and his is not a fly by night operation - family biz of 50 years standing !! So if the average householder no longer feels wealthy what will happen to economies based on financial alchemy and consumer spending /debt????Time will tell and I am sure Mr Soros will smile through it despite being only 80th on the rich list !!

Posted by kiwibob | 21.05.08, 05:22 GMT

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But it is unknown territory in a way – governments have abandoned control of the money supply before (Weimar Germany and more recently Zimbabwe) but we have never experienced such a simultaneous blowout in borrowing in both public and private sectors before.
George Soros doesn’t get everything right but he is pretty much on the money as far as the UK economy is concerned.

Posted by rick | 21.05.08, 01:17 GMT

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