Global forces take command

You would be mad to buy a house now. In recent days the Irish housing lobby – which has hijacked the economic debate in this country and made an absolute fortune in the process – has started to spin the line that ‘‘now is a good time to buy’’.

First-time buyers, the most hard-pressed financial subgroup in the country, are being urged by banks and estate agents to take the plunge. Do not be tempted, because you will only be the lemming-like suckers who bail out developers in trouble. Hold onto your cash. Guard it zealously, because prices are headed lower – not just here, but all around the world.

So while the Irish market rallied in midweek and surged again on Friday, the rest of the world is caught like a rabbit in financial headlights. Just consider the fact that Citibank borrowed last week from the investment trust of Abu Dhabi.

The giant US bank borrowed by issuing a bond that is going to pay an 11 per cent coupon (the interest rate).This is worse than a sub-prime interest rate. The problem for Citibank is that no one will lend it money. The moral of the story is that if you play with sub-prime, you eventually become sub-prime yourself.

I am writing this from the City of London, where the mood is sombre. Traders have moved from being worried about their bonuses last month to being worried about their jobs. The crucial thing to understand is that trust between the world’s large banks has evaporated.

No one wants to lend money to the bank that is about to announce another massive write-down from losses in the derivative markets. Because the banks have obfuscated, lied and been economical with the truth about their balance sheets, everyone is suspicious. There is no transparency in the market. Opacity rules the day, and there is a real sense that no one really knows where things are going next.

Therefore the attitude is one of ‘‘guilty until proven innocent’’. In conditions like this, the market dries up. With no one lending or borrowing, the world’s big banks have to depend on the central banks to keep lending cash.

Thus we have seen the Federal Reserve and the ECB pumping money into the system on a daily basis. Yet inter-bank interest rates – the rate at which banks lend to each other – continue to rise. So liquidity, the essential lubricant of the global financial system, has disappeared.

Now, this won’t last forever. The crisis will pass. However, it is likely to have serious ramifications for the world economy, because the crisis in the banking system has come at a time when the American economy is now headed for recession.

The banking system is the heart of every economy. It pumps credit into every nook and cranny of every sector. If it seizes up, the economy suffers the financial equivalent of a heart attack. And, as with humans, if the body is already weakened, the severity of the attack and the subsequent recovery will be affected.

In the US, house prices are falling faster now than at any time since the early 1990s, and the dollar is in free-fall. Meanwhile, there is a real risk of the credit crisis extending into the credit card, motor loan and commercial property sectors.

On a global level, the problem is that the only way the US economy will recover is if the Federal Reserve keeps printing money. This is what it has been doing. But there is a limit to this, because the people who lend money to America in dollars will only tolerate so much. They have effectively been defrauded, as their dollar investments have devalued so much.

Already, China has announced that it is not prepared to hold America assets indefinitely. Europeans must obviously be thinking the same way. The only way the US can redress this is by raising interest rates, and pitching the economy into recession. So it is caught between a rock and a hard place.

This dilemma has been faced by great powers in the past, most noticeably Britain, which had to allow sterling to go into free-fall after the world became aware that British power was waning.

It is far too early to begin writing the obituary on America pre-eminence. However, many people in the City of London are beginning to see the importance of big ideas and geopolitics in understanding the global picture. For the past two decades, the idea that geopolitics mattered has become less and less fashionable, as the financial markets became hostage to the ‘‘quant’’ virus.

Quantitative models, or ‘‘quants’’, have dominated the financial models of large investment banks. I noticed this first in the late 1990s, when the bank I worked for began hiring mainly Indian, Chinese and French mathematicians to build financial models based on tiny anomalies in markets. The banks then borrowed hugely, and made vast fortunes on these irregularities.

The era of the quant was also the era when understanding geopolitics came to be regarded as obsolete. It didn’t seem to matter what countries wanted, and why different countries had different interests. But now it is very much back in demand, as the financial markets realise that the political ramifications stemming from a credit crisis are very real.

If China decided not to buy American assets, what would happen? Why should Europe tolerate a rising euro against the dollar, when the European economy is hardly roaring? Why should world food prices be rising at four times the rate of inflation, and what will happen to world inflation when the pressure from rising food prices kicks in?

Pessimists believe we are entering a new era where the excesses of the past 20 years – the global policy of printing money with nothing to back it up – will come home to roost with cataclysmic results. They see house prices all over the world falling, commodity prices rising, and general chaos emerging. Many well-respected voices are predicting a definite recession in the US and, as they predict that all markets and countries will suffer contagion, some are comparing today’s market meltdown with the 1930s.

Optimists are saying that if the Federal Reserve can cut interest rates dramatically, the US consumer will start to spend other people’s money again and kick-start the economy.

The recession will be short-lived and the recovery will start with the dollar at a lower level, China that bit closer to becoming the biggest economy in the world and oil prices over $100 becoming the norm. Houses prices will fall significantly but plateau, and start moving up again.

It’s impossible to suggest which view is more accurate, but one thing is certain – these big global forces will have far more of an impact on the direction of our economy than anything announced in the Dail next week.