The economic news has seen brighter of late- the dramatic interventions by the central banks are said to have brought a return to stability in the banking system. It is true that the financial system no longer seems to be evaporating before our very eyes. However the impact on the real economy of the wrenching shock to the banks is only now becoming plain.
In fact, international banking system, through a combination of renegotiation and tight liquidity, is seeking to recapitalise itself as rapidly as possible- and several money centre banks such as Barclays and Goldman Sachs are repaying their emergency loans very quickly. The result is that despite the very loose liquidity offered by the central banks, the actual interest rates paid by corporates to the banks has actually increased substantially- and credit is still in very thin supply. The increase in the cost of money and the dramatic slowdown in demand is putting industrial production in a vice across the world. Yet it is only now that we are beginning to see the real effect of the slowdown on unemployment. Naturally unemployment is a lagging indicator, but the scale of what happened in the credit markets is not yet fully reflected in the labour markets. It is only a matter of time before we see a sustained and substantial increase in long term unemployment.
The bankruptcy of General Motors is a reflection of the process of corporate restructuring that now has to take place. GM at least is finally beginning to tackle its long term and deep seated structural problems, but many other corporations remain in denial. The knock-on effect of GM's fall will itself be substantial, and there are many other sectors- notably airlines- with similar troubles to the auto manufacturers and whose fate will be the same. Although the initial credit crisis is indeed passing, that merely means that we are moving into a deep, grinding and long term recession as the excess and inefficient capacity that was not tackled during the boom years must now be tackled after the bust.
The same applies to countries. Despite the urgency of the crisis, the government of Latvia has struggled to adjust their budget in order to cope with the results of the credit crash. Without strong action, it is becoming increasingly likely that they will face further pressure. Indeed as it becomes clear that the Swedish banks have not written off enough of their Baltic assets, the Swedish Krona has also faced pressure. Latvia is now struggling to avoid a devaluation and indeed we could see that happen very quickly after the European elections are over. Despite the very different situations in Estonia and Lithuania, it also seems possible that a Latvian devaluation would trigger a general realignment of the Baltic currencies. However, this is despite the huge amount of pain that the three economies have already taken in order to retain the credibility of their currency systems. After a recession that looks set to be around 10% this year, to be forced to take on a 20% devaluation, for example, would be a body blow to the local economies, albeit that such a move in Latvia would be now greeted with resignation rather than regret.
Nor would the rest of Europe be immune from the crash. The interventions that Angela Merkel is making concerning the monetary policy of the European Central Bank underlines the deep concern that many in Berlin have about the current loose policy. The fragility of the system is now very delicate and a Latvian crisis could have some dramatic effects upon the untested ECB systems.
The spiking of the oil market-to $69/bbl also underlines the highly uncertain and volatile state of the global energy market- another risk to global stability.
The risks in the financial markets remain substantial and the erratic liquidity and increasing expensive financing costs have not yet seen their full impact emerge. We are very far from being out of the woods yet. Despite the rally in the equity markets over the past few months, the sustainability of many business models remains in doubt.
As far as the equity markets are concerned, it could very easily be a W-shaped performance curve, rather than the V-shape that many optimists think is happening now.
I do not think we are out of the woods yet and the political, never mind the economic consequences of a double dip could end up being highly explosive.