The worst is over (not)

For almost a year, central bankers have desperately reassured us that the worst of the credit crunch was behind us. The financial system had swallowed hard and absorbed most of the sub prime losses. A slow and steady recovery was on its way. Banks would over time gradually regain their confidence. They would resume lending. As they did, asset prices would stabilize and then gradually begin their upward march.

In America at least, the events of this weekend cruelly exposed these reassurances. The IndyMac failure reminded everyone that the US banking system remains in a highly precarious position. Many banks are insolvent, and IndyMac is the first of a series of high profile failures. The GSE bailout is now firmly underway. The US taxpayer is about to absorb the financial consequences of the housing bubble. No one has the slightest clue as to how much the clean up will cost. No one expects it to be cheap.

Here in the UK, today's producer price data underlined the growing inflationary threat. Factory gate inflation hit 10 percent, yet the Bank of England seems paralysed in the face of these appalling numbers. Unable to raise rates from fear of exacerbating the banking crisis, the Bank seems ready to risk letting inflation run out of control.

So far, the real economy has not slowed. The financial sector, on both sides of the atlantic, hit the rails when unemployment was at historic lows, and economic growth was solidly above three percent.

Now, growth is slowing. Imagine what even a modest increase in unemployment would do to mortgage arrears. Banks, both here and in the US, have no capital cushion to absorb increasing losses. Even a slight increase in arrears will push many banks under water.

Imagine a terrible systemic banking crisis; imagine central banks desperately printing money to pump in liquidity into failing banks, imagine a confused crisis of confidence as wage setters anticipate higher inflation while foreign investors expect exchange rate collapses.

Imagine all of this and you will have some idea of what the future holds for the UK and US economies. The worst is not over; the worst is about to fall upon us.