Jeremy Warner's Outlook: Credit crisis that doesn't spell recession

It is unusual to have a fully blown financial crisis in the midst of August, when most of the big guns of the City and Wall Street are on holiday. The B teams left in charge are typically under strict instructions to sit on their hands and do as little as possible until the grand mufti return.

This time around the masters of the universe have been furiously bashing away at their blackberries as they bask on the sun lounger. Some have cancelled vacations and a few have even returned home early. Yet staying away from the thick of it all might have been best for it always gives a better sense of perspective. Reading the financial press from the calm of the Catalonian countryside, I've been astonished by the alarmism of the reporting.

Anyone would think that the end of global capitalism was upon us, with the whole edifice about to come tumbling down, plunging the world into a nuclear winter of economic depression. On all counts, this seems extraordinarily unlikely. What we are witnessing is rather a necessary and healthy reappraisal of credit risk which should act as corrective brake on the wilder excesses of the financial system as the economic boom reaches its zenith. When the downturn eventually comes it will consequentially be less severe and less painful.

For this reason commentators have been right to criticise the European Central Bank for its decision to flood the system with liquidity in response to the seizing up of credit markets that occurred late last week. The ECB was at it again yesterday, lending a further €47.7bn (£32bn) to distressed markets. This brings to €214bn the total amount of support provided by the ECB over the past three trading days.

I've no particular problem with the intervention as such. It is part of the job of central bankers to support the payments system by acting as lender of last resort. Credit markets which seize up are capable of inflicting considerable damage on the real economy by causing what may turn out to be a wholly unjustified and unnecessary outbreak of bankruptcies. In a credit crunch, fundamentally sound lending can end up getting punished alongside the bad stuff.

Yet by acting in this way the ECB is also removing the moral hazard on which all markets rely for their self discipline. If a lender or investor takes undue risks with their money, they should be made to suffer the consequences. Risk has become badly mispriced in the private equity- and hedge fund-inspired madness of recent years.

The danger of bailing out the rotten lending that builds up in a boom is that it encourages the party to begin afresh. If the markets believe there is always the seventh cavalry of the ECB or the Fed to come riding over the horizon, they lose all sense of financial danger. It was the wrong signal to flood the markets with cheap money and risks repeating the same mistakes of the not so dissimilar financial crises of 1987 and 1998. In both instances, interest rates were cut to help deal with the apparent meltdown in financial markets. This only further fuelled the latter stages of the boom and made the eventual downturn that much worse.

The approach adopted this time around by the Bank of England on market intervention seems a much more sensible one. While the ECB and the Fed have been flushing the system with liquidity, the Old Lady of Threadneedle Street has been notable through her absence. Yet this is not because the Bank of England has refused to lend. Recent reforms instead mean that banks can borrow whenever they want, but only at a punishing one percentage point above base rate. This seems to provide a reasonable middle way between the need to protect the credit system and the extraction of some sort of penalty from those forced into distress borrowing.

In any case, no central bank should be cutting interest rates in response to a liquidity crisis of the type we have just seen. Only when conditions in the capital markets show clear signs of undermining activity in the real economy should such action be considered. As yet there is no evidence of this.

With stock markets staging a pronounced recovery yesterday, is the crisis already over? It would be plain daft to bet on it quite yet. Investors have become easily spooked, and the theory that there are some big players out there with massive undisclosed, perhaps as yet unsuspected, losses on their balance sheets refuses to go away.

Fear of the unknown has become the main negative. Suddenly everyone is an expert on the deeper mysteries of derivative markets and barely a moment passes without some new bogey, real or imagined, leaping out of the black box that lies beneath the bonnet of global financial markets. Earlier this year it was the yen carry trade that underpinned all the predictions of financial armageddon. Today it is collateralised debt obligations, structured investment vehicles, conduits, asset-backed commercial paper, and so on.

It is not really necessary to understand these products to recognise the nature of the problem, which is fundamentally no different from previous credit squeezes. As hedge funds have struggled with mounting losses, banks have called in the debts these funds use to enhance their returns, or severely limited access to leverage.

This has forced some funds to liquidate trading positions wholesale, compounding the turmoil in markets. At the same time, banks have been unable to refinance a number of big private equity transactions on the anticipated terms, which means that they could be left with big losses on their books. Scary, but probably containable.

Yet the idea that everything will resume just as it was when things have settled may be as misplaced as the warnings that credit markets are about to plunge us all into recession.

Bankers have had a frighteningly loud wake-up call and the evidence is that they may actually have sat up and taken note. Spreads have widened markedly, with many hedge funds and private equity players now finding their access to credit restricted. If this helps curtail hedge-fund and private-equity activity, it may eventually make securities trading less volatile and alleviate some of the public interest concerns which have been voiced about global capital markets over the past year. That can surely be no bad thing.

As for the real economy, as well as the great bulk of the companies that make it up, the crisis is no more than a storm in a tea cup. The world economy continues to look fundamentally sound, even in the US, where weaker consumption should soon be answered with cuts in US interest rates. The financial system may be overgeared, but corporate balance sheets and earnings have never been stronger.

In the stock market, earnings multiples are no more than average and, at this stage, the liquidity flowing out of Asia and the oil-rich economies of the Middle East and Russia remains as buoyant as ever. Inflation still looks like more of a threat than recession, but the inflationary pressures are not yet so severe that they require real interest rates so high that they inflict severe economic damage. My guess is that the bull market isn't over quite yet.

ICI agrees 670p a share from Akzo

When Lord Hanson took a tilt at ICI in the early 1990s, there was universal outrage over what was seen as an act of banditry against an iconic British company. Now ICI is being sold to the Dutch chemicals concern Akzo Nobel, and nobody other than a few Akzo shareholders who fear their company is overpaying at the top of the cycle, seem in the least bit concerned.

ICI has been through the wars since Hanson's abortive attempt to board, but it is still fundamentally a decent company with a powerful and growing position in paints, coatings and adhesives. Akzo has just about made the numbers stack up by agreeing to sell the adhesives business to the German company Henkel, which is capable of achieving more synergies.

The starch operation is also likely to be sold. So ICI ends up broken up as well as taken over. There's a curious symmetry in it all, as that is precisely what Barclays and Royal Bank of Scotland are intending to do with ABN Amro, the Dutch bank. The world has indeed changed since Lord Hanson walked the planks.

j.warner@independent.co.uk

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