2007 Revisited?

THERE was a whiff of August 2007 in the air on Thursday and again today as financial markets tumbled around the world. More than a whiff, in fact. The familiar stench of panic was back as shares fell heavily, bond yields in Spain and Italy rose and the search for a haven sent the price of gold to a record level. Banks took an especially severe pummelling amid fears that they were exposed to the two big concerns of investors: a break-up in the euro zone and a double-dip recession in the global economy.

In a week of anniversaries, Thursday was a day that conjured up all the wrong sort of memories. It was 97 years since Britain declared war on Germany, when the resulting financial turmoil meant the stockmarket, which had closed at the end of July, did not reopen for business until early 1915. Yet even in the month or so after the assassination at Sarajevo, when the great powers gave up on diplomacy and prepared for conflict, the movements in financial markets were less violent than they were on Thursday.

More recently, it is almost four years since an announcement by French bank BNP Paribas that it was temporarily suspending three hedge funds specialising in United States subprime mortgage debt led to financial paralysis. Banks, it was discovered, had lent unwisely, were loaded up with toxic derivatives that were vulnerable to falling American house prices, and had far too little capital set aside for a rainy day. On August 9, 2007, the heavens opened. On the face of it, the banks are in better shape than they were when British bank Northern Rock became the first major UK high-street lender to suffer a bank run since Overend & Gurney in the 1860s. They have been forced to build up capital reserves and to hold a higher proportion of their assets in liquid form - financial instruments such as government bonds that can be quickly turned into cash.

Financial regulators have spent the past four years crawling all over the banks, making up for the not-so-benign neglect in the days leading up to the crisis, when supervision was far too lax. Britain's Financial Services Authority, the European Banking Authority and America's Federal Reserve know where all the bodies are buried in their respective banks. In theory, at least. One of the parallels between August 2007 and August 2011 is the shiftiness of those running the show, a sense that they are not letting on all they know for fear of creating more panic.

The dwindling band of optimists point to differences with four years ago. Many companies, especially the bigger ones, are in rude financial health after cutting costs aggressively. Parts of the emerging world, such as China and Russia, are growing strongly and may act as the locomotive for the rest of the world. In the West, interest rates are low and budget deficits high: policymakers have pressed the pedal to the floor in an attempt to get their economies moving.

But the ultra-loose state of macro-economic policy cuts both ways. Policymakers were the heroes of Meltdown 1, thumbing through their copies of Keynes's General Theory to come up with the measures deemed necessary to prevent the global banking system from imploding. But if the next few weeks see Meltdown 2, the policy options will be limited. Interest rates are already at rock-bottom levels while the flirtation with Keynesian fiscal policies was brief. As one analyst put it yesterday, the monetary and fiscal guns are not obviously full of bullets. Thursday's mayhem will fan speculation that the Federal Reserve will respond with a third dose of electronic money creation through the process known as quantitative easing.

Not that the $US2 trillion the US central bank has already pumped into the global economy appears to have had much effect, apart from to provide more casino chips for speculators and to push up food and energy bills around the world. There was a colossal stimulus provided in the northern winter of 2008-09 but the results have been profoundly disappointing. Cheap money and big budget deficits certainly averted a second Great Depression, a very real prospect three years ago when no bank looked safe and factories were lying idle, and that is success of a sort. But it has not produced the normal snap back from recession seen during the post-Second World War era. Indeed, the deepest recession since the 1930s has been followed by the feeblest recovery.

The global downturn of 2008 was a different sort of recession - one caused by banks and individuals borrowing far more than was good for them, rather than one caused by central banks raising interest rates in response to higher inflation. It's a different sort of recovery as well - weak, stuttering and at risk of being aborted at any moment.

In one sense, the mood is different from August 2007. Back then, financiers and politicians spent the first six months after the crisis broke in a state of denial, expecting the return of business as usual. They didn't really get it until the collapse of Lehman Brothers in September 2008. Financial markets were taken unawares by Lehmans, but this is a week that has seen the US taken to the brink of debt default, a deal to safeguard the single currency start to unravel within a fortnight of it being agreed, and a steady drip-feed of downbeat economic news. Only a mug would call Thursday's events a ''Lehmans moment''.

Stockmarkets tend to anticipate change. They rise at the bottom of the cycle in anticipation that economic conditions will improve, and they fall when they assume that things are about to take a turn for the worse, which is what they expect now. It is not just that growth appears to be flagging everywhere, even in China. It is the concern, cruelly exposed in Greece, Portugal, Ireland, Italy, Spain and even the US, about the solvency of nation states.

Back in 2007, the one comfort for markets was that a banking crisis never became a sovereign debt crisis. Now it has, and markets are scared witless as a result.