John Rapley

When the world's major central banks began raising interest rates a couple years ago, financial markets sailed happily past them. By boosting the cost of borrowing from governments, central bankers hoped to reduce the amount of credit that entered the world economy, thereby restraining inflation.

But in a globalised world, less and less of the money that businesses and consumers spend comes from governments. Private lenders continued to drop interest rates and offer their customers easy credit. So the global economic boom just continued. Housing, stock and bond markets continued rising, defying the efforts of central bankers to rein things in a bit.

Then, a few weeks ago, a sharp sell-off in global bond markets seemed to indicate that the central bankers had finally got through to their audiences. Interest rates surged.

Us credit tightened

Even before then, developments in the United States suggested that credit was tightening. Years of cheap money had led mortgage lenders to offer home loans on terms more generous than ever before seen: no down payments, low interest, even reduced payments for the first year. The 'subprime' boom took off. Market enthusiasts celebrated it as proof that the American Way was working, making the dream of home-ownership a reality for more people than ever before.

But what goes up, must eventually come down. So many people bought houses that prices surged beyond rational levels. Eventually, this inflation priced new buyers out of the market. Then, as easy credit terms ended, many weaker borrowers couldn't meet payments. As payments dried up, mortgage lenders had to chalk up losses and sell properties. The consequent glut of new sales drove down prices, further eroding balance sheets.

In the last few weeks, a few big mortgage firms went to the wall. As their share prices collapsed, hedge funds that had bought into them recorded losses of their own. This, in turn, caused them to reduce their own lending and buying, reducing demand for shares. Equally, some funds began to sell foreign assets to cover their losses. The U.S. cough thereby sent shivers through world markets.

Many investors are hoping that the world's central banks will step in if the fall in stock markets turns into a rout. The last time that happened, a decade ago, they did just that. But things may be different this time around.

First, inflation remains a threat. Stock and house prices may be falling, but commodities continue rising. Oil is touching record levels. Meanwhile, there's little evidence that the market contagion is spreading to the economy. Employment in the U.S. remains high. Elsewhere, Asia and Europe are both healthy. For the time being, the call for central banks to make credit cheap again is really an argument to defend the wealth of the super-rich, who made huge gains off rather reckless behaviour.

Only if the meltdown reaches a point that consumers begin to rein in spending, thereby driving the U.S. into recession, would the U.S. Federal Reserve Board likely act. Even then, it's not clear its counterparts elsewhere would react in kind. Inflation in economies as diverse as Britain and China is rising. It's unlikely those banks would take a chance of worsening their own macroeconomic conditions just to rescue the overstretched American consumer.

True, if the U.S. economy goes into recession, pulling down the rest of the world with it, central banks would have to forget about inflation and make credit cheap again. But we are probably a long way from that. For now, we may witness a fairly wide roller-coaster ride in global markets. Money may be made, but it won't be as easy as it was.