Economic slowdown: World markets fall sharply amid fears that credit crunch has further to run

• Larry Elliott, economics editor
• The Guardian,
• Wednesday August 20 2008

Share prices dropped sharply on the world's financial markets yesterday amid fears that the year-long credit crunch is entering a dangerous new phase marked by a severe economic slowdown and failing banks.

The FTSE 100 index fell by almost 2.5% as financial market traders braced themselves for a fresh bout of turbulence triggered by concern that weakening growth in Europe, North America and Asia would add to the problems of western banks.

Analysts pointed to widening spreads in money markets as a sign that the mood was becoming gloomier after a period in which trading conditions had showed tentative signs of returning to normal. A fall of 129.8 points in the FTSE 100 to 5320.4 was mirrored by a drop of almost 3% in Japan, and declines of well over 2% on the Frankfurt and Paris bourses.

Ken Rogoff, the former chief economist at the International Monetary Fund, added to market jitters by warning that the worst of the crisis was yet to come.

"The US is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say 'the worst is to come'," he told a financial conference in Singapore.

"We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper, we're going to see a big one - one of the big investment banks or big banks," Rogoff said.

His comments came amid speculation that the US government would in effect be forced to nationalise Fannie Mae and Freddie Mac - the two biggest US housing finance groups and as new figures for housing starts and producer prices suggested that the world's biggest economy was in the grip of stagflation.

After a fall of more than 180 points on Monday, shares on Wall Street slipped further in early trading yesterday. Lehman Brothers was down more than 6% after reports from analysts that it would be forced into a fresh $4bn (£2bn) write-down from losses on the US real estate market.

The US commerce department in Washington reported an 11% drop in housing starts between June and July - dousing hopes that the market might be stabilising after the most severe property slump since the Great Depression. With the US awash with unsold homes, builders began work on 965,000 properties last month - a 30% fall on July 2007.

Meanwhile, data from the US labor department provided evidence of last month's rise in oil prices to a peak of $147 a barrel. The producer price index - a measure of the cost pressures facing American manufacturers - was 9.8% higher in July than it was a year earlier. It is the fastest annual rate of growth since 1981.

Even excluding food and energy - the two items that have been mainly responsible for growing upward pressure on the cost of living - producer prices were still 3.5% higher than a year earlier, the fastest rate of increase since 1991.

Richard Fisher, head of the Dallas Federal Reserve, said: "We are in the midst of a fierce correction from a period of indiscriminate behaviour in the credit markets, a surfeit of homebuilding, a global avalanche of cheap labour and correspondingly cheap imports, and other unsustainable financial and economic activity."

But Fisher - seen as one of the Fed's hawks - warned that the fight against rising inflation had to take precedence over cuts in interest rates to boost growth.

"Unless the python that is the US economy can quickly pass the recent burst of cost-push pressures, we risk a reinforcing spreading of inflationary impulses and expectations," he told the Progress & Freedom Foundation thinktank.

"Should this happen and the Fed were to fail to address it, we would run the risk of losing the public's confidence in our ability to constrain inflation," he said.

Gabriel Stein, at Lombard Street Research, said credit growth in the US had remained strong until the late spring but had since weakened sharply.

"The demand for loans is not there, nor are banks willing to extend credit even if it were. If this weakness becomes entrenched over the autumn, it is a clear sign of very weak American output growth in 2009," he said.