Waiting for the crash

Observations on world economy

When the world's powerful people gathered amid the snows of Davos in late January, there was a tangible warm glow being given off by the economic cycle. "The message was: it's going to be good in 2007 and not bad in 2008," says Mark Spelman, head of strategy at the consulting firm Accenture. Six weeks later, the financial markets are in turmoil and what was at first shrugged off as a "correction" is being seriously monitored as a potential crash.

But why? Corporate profits are buoyant. According to economists at the investment bank Dresdner Kleinwort, worldwide earnings-per-share should grow at 8.8 per cent this year and 10.9 per cent the next. The answer lies in a mismatch between the steady upward trend in the real economy and the crazy, near-vertical optimism of the markets. "People had undervalued risk," says Spelman, "assuming that because the economy is benign there's not going to be volatility."

The Shanghai Composite Index had risen 300 per cent since mid-2005, with small investors selling homes and taking out loans to get into the action: the tell-tale signs of a bubble. Not even China's spectacular GDP growth rate of 9 per cent could sustain it. But while emerging markets have crashed before, this time there was a difference. "It's the first time I can remember that a market outside of America had a global impact," says Clem Chambers, CEO of the investment website ADVFN. "Last week, China caught a cold and America got pneumonia."

The fear now is that, as investors run away from risk, they take losses and expose problems previously masked by the sheer complexity of modern financial instruments - and that this in turn begins to impact on the real-world economy. Attention is focused on four threats which, in their over-optimism, policy-makers at Davos had downplayed.

First, the threat of an American recession. It took the former Federal Reserve boss Alan Greenspan to issue the wake-up call: it was his speech warning of a "possible but not probable" US recession in 2007 that triggered Wall Street's reaction to the Chinese market's slide. Greenspan intervened again on 6 March, refining that prediction to a "one in three chance" of recession before Christmas. Then came a slew of bad figures in the US: productivity growth has now dropped off, and factory orders fell faster than at any other time in the past six years. Then the US government revealed that, instead of growing at 3.5 per cent in the final quarter of last year, the economy had in fact grown at only 2.2 per cent.

The second big fear is about the unfolding credit crisis in the US. Seven out of the top 25 mortgage lenders are in default. The big banks are having to set aside billions for bad debt: HSBC alone wrote off $10bn this past week. The practice of parcelling up these mortgages into complex "derivatives", which then become a "pass the parcel" game in the markets, has also unnerved central bankers. Nobody knows in whose lap the nastiest surprise will land.

Third, there is the question of whether high finance is itself overborrowed. Since the last stock market collapse, in April 2000, hedge funds have become far more central to the financial system: one of their main tactics is "leverage" - borrowing huge sums in order to amplify their return on investment. One hedge-fund insider told me this week: "The markets have finally copped on to the amount of risk in the form of leverage that exists in the market. If you strip out leverage from hedge-fund returns, then the performance for the past 18 months would be pretty poor." The fear is that, when high-risk investments come unstuck, this huge leverage will amplify the losses, which will then cascade over to the banks that lent the money.

The fourth worry is the dependence of western economic growth on China. Nobody expects a severe economic slowdown there: the question is, could China and the rest of Asia take the strain if the western economies slow down? "If America goes into full recession, there are not enough springs in Europe and Asia to compensate: that would be serious," says Spelman.

Which brings us back to Davos. At Davos the big brains of global capitalism were worried about structure, not cycle. They were prepared to think deep, dark, après-ski thoughts about the imbalance between China and America; the growth of hedge funds and derivatives; and the fractiousness of geopolitics. But these were problems that could be surveyed at leisure, sure in the knowledge that the direction of the economy was positive. The simultaneous rout of stock markets in Shanghai, London, Frankfurt and New York changed that. Chambers, a legendary perceiver of patterns at times of instability, believes there's a 25 per cent chance the markets will fall by the same amount again - and soon.

Paul Mason is the business correspondent of BBC Newsnight. His book "Live Working or Die Fighting: how the working class went global" will be published by Harvill Secker on 5 April

This article first appeared in the 12 March 2007 issue of the New Statesman, Iraq: the hidden cost of the war

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Q&A: What are tax credits and how do they work?

All you need to know about the government's plan to cut tax credits.

What are tax credits?

Tax credits are payments made regularly by the state into bank accounts to support families with children, or those who are in low-paid jobs. There are two types of tax credit: the working tax credit and the child tax credit.

What are they for?

To redistribute income to those less able to get by, or to provide for their children, on what they earn.

Are they similar to tax relief?

No. They don’t have much to do with tax. They’re more of a welfare thing. You don’t need to be a taxpayer to receive tax credits. It’s just that, unlike other benefits, they are based on the tax year and paid via the tax office.

Who is eligible?

Anyone aged over 16 (for child tax credits) and over 25 (for working tax credits) who normally lives in the UK can apply for them, depending on their income, the hours they work, whether they have a disability, and whether they pay for childcare.

What are their circumstances?

The more you earn, the less you are likely to receive. Single claimants must work at least 16 hours a week. Let’s take a full-time worker: if you work at least 30 hours a week, you are generally eligible for working tax credits if you earn less than £13,253 a year (if you’re single and don’t have children), or less than £18,023 (jointly as part of a couple without children but working at least 30 hours a week).

And for families?

A family with children and an income below about £32,200 can claim child tax credit. It used to be that the more children you have, the more you are eligible to receive – but George Osborne in his most recent Budget has limited child tax credit to two children.

How much money do you receive?

Again, this depends on your circumstances. The basic payment for a single claimant, or a joint claim by a couple, of working tax credits is £1,940 for the tax year. You can then receive extra, depending on your circumstances. For example, single parents can receive up to an additional £2,010, on top of the basic £1,940 payment; people who work more than 30 hours a week can receive up to an extra £810; and disabled workers up to £2,970. The average award of tax credit is £6,340 per year. Child tax credit claimants get £545 per year as a flat payment, plus £2,780 per child.

How many people claim tax credits?

About 4.5m people – the vast majority of these people (around 4m) have children.

How much does it cost the taxpayer?

The estimation is that they will cost the government £30bn in April 2015/16. That’s around 14 per cent of the £220bn welfare budget, which the Tories have pledged to cut by £12bn.

Who introduced this system?

New Labour. Gordon Brown, when he was Chancellor, developed tax credits in his first term. The system as we know it was established in April 2003.

Why did they do this?

To lift working people out of poverty, and to remove the disincentives to work believed to have been inculcated by welfare. The tax credit system made it more attractive for people depending on benefits to work, and gave those in low-paid jobs a helping hand.

Did it work?

Yes. Tax credits’ biggest achievement was lifting a record number of children out of poverty since the war. The proportion of children living below the poverty line fell from 35 per cent in 1998/9 to 19 per cent in 2012/13.

So what’s the problem?

Well, it’s a bit of a weird system in that it lets companies pay wages that are too low to live on without the state supplementing them. Many also criticise tax credits for allowing the minimum wage – also brought in by New Labour – to stagnate (ie. not keep up with the rate of inflation). David Cameron has called the system of taxing low earners and then handing them some money back via tax credits a “ridiculous merry-go-round”.

Then it’s a good thing to scrap them?

It would be fine if all those low earners and families struggling to get by would be given support in place of tax credits – a living wage, for example.

And that’s why the Tories are introducing a living wage...

That’s what they call it. But it’s not. The Chancellor announced in his most recent Budget a new minimum wage of £7.20 an hour for over-25s, rising to £9 by 2020. He called this the “national living wage” – it’s not, because the current living wage (which is calculated by the Living Wage Foundation, and currently non-compulsory) is already £9.15 in London and £7.85 in the rest of the country.

Will people be better off?

No. Quite the reverse. The IFS has said this slightly higher national minimum wage will not compensate working families who will be subjected to tax credit cuts; it is arithmetically impossible. The IFS director, Paul Johnson, commented: “Unequivocally, tax credit recipients in work will be made worse off by the measures in the Budget on average.” It has been calculated that 3.2m low-paid workers will have their pay packets cut by an average of £1,350 a year.

Could the government change its policy to avoid this?

The Prime Minister and his frontbenchers have been pretty stubborn about pushing on with the plan. In spite of criticism from all angles – the IFS, campaigners, Labour, The Sun – Cameron has ruled out a review of the policy in the Autumn Statement, which is on 25 November. But there is an alternative. The chair of parliament’s Work & Pensions Select Committee and Labour MP Frank Field has proposed what he calls a “cost neutral” tweak to the tax credit cuts.

How would this alternative work?

Currently, if your income is less than £6,420, you will receive the maximum amount of tax credits. That threshold is called the gross income threshold. Field wants to introduce a second gross income threshold of £13,100 (what you earn if you work 35 hours a week on minimum wage). Those earning a salary between those two thresholds would have their tax credits reduced at a slower rate on whatever they earn above £6,420 up to £13,100. The percentage of what you earn above the basic threshold that is deducted from your tax credits is called the taper rate, and it is currently at 41 per cent. In contrast to this plan, the Tories want to halve the income threshold to £3,850 a year and increase the taper rate to 48 per cent once you hit that threshold, which basically means you lose more tax credits, faster, the more you earn.

When will the tax credit cuts come in?

They will be imposed from April next year, barring a u-turn.

Anoosh Chakelian is deputy web editor at the New Statesman.