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The surprise of recent months is not that global economic growth is slowing, but that there is any growth at all. The credit crunch of the past year has not followed the path of recent economically debilitating episodes characterised by a temporary freezing up of liquidity - 1982, 1989, 1997-98 come to mind. This crisis is different - a once or twice a century event deeply rooted in fears of insolvency of major financial institutions.
This crisis was not brought to closure by the world's central banks' injection of huge doses of short-term liquidity. Only when sovereign credits were substituted for private bank credit, first in the case of the UK (Northern Rock) and subsequently in the case of the US (Bear Stearns), was a semblance of stability restored to markets.
But the London Interbank Offered Rate spreads on overnight index swaps and credit default swaps of financial institutions have not returned to the modest pre-crisis levels. Fears of insolvency have not, as yet, been fully set aside. There may be numbers of banks and other financial institutions that, at the edge of defaulting, will end up being bailed out by governments.
The insolvency crisis will come to an end only as home prices in the US begin to stabilise and clarify the level of equity in homes, the ultimate collateral support for much of the financial world's mortgage-backed securities. However, US home prices will stabilise only when the absorption of the huge excess of single-family vacant homes that emerged as the US housing boom peaked in 2006 is much further advanced than it is now.
New single-family home completions are currently barely under the rate of home demand generated by household formation and replacement needs. Only later this year will the current suppressed level of housing starts be reflected in completion levels consistent with a rapid rate of liquidation of the inventory glut, and this, of course, assumes that current levels of demand for housing hold up.
Pending that outcome, the price of equities worldwide will determine whether the international financial system can maintain a modicum of stability as it eases out of its credit crunch, or falls back into another period of angst and turmoil.
The optimistic case rests on the business world beyond finance. Given this past year's vast impairment of financial intermediation, non-financial corporate business has held up surprisingly well, contributing to a flow of corporate earnings that has helped sustain a stressed global stock market. To be sure, global stock prices are off a fifth from their October 2007 peaks, but still hover at levels last seen in 2006, a demonstrably less fear-ridden period than currently prevails.
A sustained level of global equity prices will be critical if banks are to recapitalise themselves at the higher levels daunted investors now require. The pool of capital is being augmented by a reasonably high level of saving (nearly 24 per cent of world gross domestic product), up significantly from earlier this decade. The flow of new saving will provide some support.
Capital gains
Capital gains, however, are just as important. This can best be observed in the context of the consolidated balance sheet of the world economy. All debt and derivative claims offset in global accounting, leaving real physical and intellectual assets and their market value reflected as net worth.
Capital gains cannot finance new physical investment, but do add to global net worth. If discounting of prospective future earnings engendered by the world's physical capital stock declines, the market value of that capital stock rises with no offsetting liability.
There is accordingly a larger value of equity shoring up the capital of financial or non-financial businesses. Should that discount rate reverse, the value of world equity will fall. Consequently, lower global stock prices could impede the recapitalisation of banks and other financial institutions. Debt issuance would also be suppressed as it leverages off the level of equity.
The economic edifice - market capitalism - that has fostered this expansion is now being pilloried for the pause and partial retrenchment. The cause of our economic despair, however, is human nature's propensity to sway from fear to euphoria and back. Regulation, the alleged effective solution to today's crisis, has never been able to eliminate history's crises.
A financial crisis is heralded, in fact defined, by sharp discontinuities of asset prices. The crisis must thus be unanticipated. The fact that risk was heavily underpriced for much of this decade was broadly recognised in the financial community, but the timing of the sharp price correction was a surprise.
We may not easily confront or accept the price dynamics of home and equity prices, but we can fend off cries of political despair which counsel the containment of competitive markets. It is essential that we do so. The remarkably strong performance of the world economy since the near universal adoption of market capitalism is testament to the benefits of increasing economic flexibility.
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