Business comment: Sub-prime crisis is the edge of a financial hurricane By Bernard Connolly It is hard to overstate the seriousness of the global financial crisis. Yet the world's central monetary authorities - the central banks - have been culpably slow to recognise how dangerous things have become. Initially, the crisis emerged from the US mortgage market, as payment delinquencies among sub-prime borrowers (borrowers in poor credit standing) began to mushroom. Things will get much worse as US unemployment begins rising, perhaps rapidly, making it harder for more and more borrowers to maintain timely interest and principal repayments on their mortgages. As long as US house prices were rising, it always seemed possible for homeowners who got into trouble to take out additional loans, in effect borrowing to finance their earlier borrowings: a classic Ponzi game. But when the oversupply of new houses in the US began forcing prices down instead of up, the avenues to ever-more borrowing were shut off, at least for late entrants into the game, the people who had been unable to build up enough equity in their houses via the earlier period of rising prices. But US sub-prime is just the leading edge of a financial hurricane. For far too long, no-one seemed to care if borrowers would be able to service their debts: borrowers themselves seemed not to care; lenders seemed not to care; and investors in the packages of mortgage loans created by banks and sold to institutions such as pension funds seemed not to care. In short, there was a global credit bubble. The root cause of a credit bubble is not financial market greed (though that has certainly been present) but an inappropriate level of real interest rates that sends misleading signals about the feasibility of continuing to consume today while ignoring tomorrow. In the US in the mid-1990s, the former Fed chairman, Alan Greenspan, ignored the message of the 1920s and failed to engineer a rise in real rates to match a rise, driven by optimism about productivity, in the expected rate of return on investment in the US economy. The late-1990s result was, as in the late 1920s, a frenetic stock market boom, massive business over-investment financed by credit, not by postponed consumption (saving), and an inevitable collapse. Greenspan did manage to avoid, or at least to postpone, a re-run of the early 1930s by slashing interest rates in 2001 when the US economy threatened to fall off the edge of a cliff. That is a performance his successor is going to have to repeat now that the US housing and credit booms have collapsed. In the US, the Fed is belatedly recognising that what is now happening is not a "healthy correction" of the previous under-pricing of risk but a virulent infection running rapidly through the financial system, threatening to inflict severe structural damage on the real economy. Its decision announced last Friday to cut the Discount Rate, the rate at which financial institutions can borrow directly from the Federal Reserve Banks, was a step in the right direction. But it will not be anything like enough. The Fed is going to have to make very substantial cuts in the general level of interest rates if it is going to have any chance of preserving financial stability and avoiding an extremely serious recession. It will do that, even if it does not yet realise just how much it is going to have to do, because its mandate will make it do it. The Fed was created, in response to the 1907 financial crisis in the US, precisely to try to avoid further crises. And, whatever mistakes Greenspan may have made, he just got it wrong: he didn't deliberately set up this Greek Tragedy. In contrast, the EU quite deliberately created the most dangerous credit bubble of all: EMU. And, whereas the mission of the Fed is to avoid a financial crisis, the mission of the ECB is to provoke one. The purpose of the crisis will be, as Prodi, then Commission president, said in 2002, to allow the EU to take more power for itself. The sacrificial victims will be, in the first instance, families and firms (and banks and investors) in countries such as Ireland and Club Med. Subsequently, German savers (or British taxpayers) will bear the burden of bailouts that a newly-empowered "EU economic government" will ordain. The mechanism is plain to see. Germany entered the euro with an overvalued exchange rate. It then faced a long period of high unemployment that drove wages down and restored its competitive position. But Germany was also helped at the beginning of this process by the newly-established ECB, then dominated by the Bundesbank president, Tietmeyer, and his acolyte, Trichet, then governor of the Banque de France. The ECB initially set interest rates where Germany needed them - far too low for most other EMU countries - and allowed extreme euro weakness. That combination, and Germany's initial uncompetitiveness, created booms in many other EMU countries. But, as in the US in the 1920 and again in the 1990s, inappropriate interest rates and temporarily booming growth totally distorted perceptions of today versus tomorrow. The result has been that firms and families in these countries have massively over-borrowed and banks and investors have massively over-lent, often on the illusory security of inflated house prices. Several of these countries have built up enormous current account deficits. They are now the ones that over the next decade will have to restore competitiveness. But, trapped in EMU, they can do that only through unemployment and wage reductions. Very high unemployment and deflation will make debts simply unpayable. But, trapped in EMU, these countries cannot do for themselves what Greenspan did and Bernanke will have to do - slash interest rates. And Tietmeyer's successor, Weber, will be striving to ensure the ECB does not do it for them. The resulting carnage in the financial system of the whole euro area will make the present global financial crisis, serious though it is, seem almost insignificant. Eventually, when things have got bad enough, the German public will be forced to acquiesce in lowered interest rates and high German inflation. But by then the EU will have taken the opportunity to seize control of the financial system (cheerfully punishing the London financial "casino" in the process), dictate budgetary policies, extort bail-out transfers from countries such as Britain and impose exchange controls with the rest of the world (and even, as reportedly threatened in a 1998 meeting of the EU Employment Committee, impose exit taxes - expropriation of life savings - on people seeking to flee the EU). And it will seek to "democratise" this power grab by instituting an emergency "European government". Would Britain resist? The revived "constitution" now being rammed through allows future constitutional changes to be made just on the say-so of a cabal of heads of government, with no need for ratification. Would any British prime minister be prepared - or be allowed - to do his duty and say no in such a carefully-manufactured emergency? The history of the past fifty years offers no reassurance whatsoever. Bernard Connolly is global strategist for Banque AIG and the former head of economic research for the European Commission Watch.