We are now witnessing the terrifying second stage of the credit crunch

Ben Chu

IT is all frighteningly familiar. In August 2007 a French bank, BNP Paribas, rocked the financial world when it announced it was suspending payments to investors in three of its hedge funds.

That event marked the beginning of a chain of events that saw the global financial system reach the brink of meltdown. A credit crunch was followed by an international banking crisis and, ultimately, a global recession.

Now, four summers on, a financial market panic has provoked fears of another credit crunch and, perhaps, another slump. So how did we come to this? The answer is that the underlying disease that almost destroyed the global economy in 2008 was never cured, merely put into remission. And, like cancer, it has now returned. The cancer has a name: bad debt. In the decade after the turn of the millennium, parts of the Western world experienced a credit boom that was unprecedented in scale. Banks relaxed their lending standards and sprayed money at consumers, companies and nation states alike.

In 2007, it finally dawned on the financial industry that there was no way that many of those who owed money could afford to pay it back. In response, they first stopped lending to those banks that looked like they had overextended themselves. Then, after the giant American investment bank, Lehman Brothers, went bust, total panic took hold. No one could borrow, except at extortionate rates. The global economy suffered a financial heart attack. That was only brought to an end when national governments injected hundreds of billions of dollars of new capital into the world's largest banks and financial institutions in the autumn of 2008.


But the banks were never properly purged of their bad debt. Sub-prime mortgages were written down in 2008 and 2009. But these banks had also lent heavily to us and other states on the European periphery, such as Greece and Spain. And that debt now looks like it might be as worthless as sub-prime mortgages. And once again investors are wary of lending to banks because they worry they might go bust. This is what is feeding fears of a second credit crunch. But this latest outbreak of panic comes with a dark twist. Cheap credit fuelled economic expansion in Europe and the US during the boom years.

And now that the credit steroid has been removed, growth has stalled. Without growth, even the wealthiest nations will struggle to service their debts. Alarm about the scale of bad debt in southern Europe has combined with wider fears about the general sustainability of borrowing levels across the world. So what happens next? That depends on whether policymakers can assuage the fears of the markets about the solvency of banks and nations. Are they willing to rescue bust financial institutions again?

And are they willing to stand behind troubled European states? It will not be easy. There will be intensehostility to another bank bailout internationally. And the populations of stronger European nations such as Germany do not like the idea of guaranteeing the debts of their southern neighbours. As for growth, the policy cupboard looks bare. Interest rates have been slashed already. And there is a powerful lobby against further fiscal stimulus, even in those nations which could afford it.

Most economists now agree that the great crisis of 2008 was unavoidable. Those bad debts could not be ignored any longer and had to be written down. The scariest thought of all is that the world could now be embarking on the inevitable second stage of that same agonising process.