As John Maynard Keynes is alleged to have said: “When the facts change, I change my mind. What do you do, sir?” I have changed my mind, as the panic has grown. Investors and lenders have moved from trusting anybody to trusting nobody. The fear driving today’s breakdown in financial markets is as exaggerated as the greed that drove the opposite behaviour a little while ago. But unjustified panic also causes devastation. It must be halted, not next week, but right now.
The time for a higgledy-piggledy, institution-by-institution and country-by-country approach is over. It took me a while – arguably, too long – to realise the full dangers. Maybe it was errors at the US Treasury, particularly the decision to let Lehman fail, that triggered today’s panic. So what should be done? In a word, “everything”. The affected economies account for more than half of global output. This makes the crisis much the most significant since the 1930s.
First of all, the panic must be dealt with. This has already persuaded some governments to provide full or partial guarantees of liabilities. These guarantees distort competition. Once granted, however, they cannot be withdrawn until the crisis is over. So European countries should now offer a time-limited guarantee (maybe six months) of the bulk of the liabilities of systemically important institutions. In the US, however, with its huge number of banks, such a guarantee is neither feasible nor necessary.
This time-limited guarantee should encourage financial institutions to lend to one another. If it does not do so, central banks must lend freely, even on an unsecured basis, to institutions too systemically significant to be allowed to fail.
By these means, the flow of credit should restart. But governments cannot allow banks to gamble freely with the public sector’s balance sheet. During the period of the guarantee, governments must exercise close oversight over the institutions they have decided to protect.
The second priority is recapitalisation. The big lesson of the crises of recent history – as an excellent chapter in the International Monetary Fund’s latest World Economic Outlook shows – is that “policymakers should force the early recognition of losses and take steps to ensure that financial institutions are adequately capitalised”.
Recapitalisation is essential if institutions are to be deemed creditworthy after the guarantees are withdrawn. Governments should insist on a level of capitalisation that allows for further write-offs. They should then either underwrite a rights issue or purchase preference shares. Either way, governments should expect to make a profit on their investments when these institutions return to health, as they should do.
Such recapitalisation is an alternative to forced debt-to-equity swaps. I do find the latter an attractive idea. Yet today it is sure to increase the hysteria, unless it can be made credibly once-and-for-all. Some will also note that my ideas are designed to avoid a shrinkage of the balance sheets of the core financial system. Some shrinkage of the financial system is inevitable, however, particularly in the US and UK. It should be allowed to occur in the so-called “shadow banking sector”.
This leads to a third question: what to do about the bad assets? Sometimes it makes sense to take such assets from the banks. That is what the new US “troubled asset relief programme” (Tarp) is designed to do. Because bad US assets are widely distributed across the world, the US programme to create a market for these assets – and perhaps raise their prices to a higher equilibrium level – will benefit many other banking systems.
Elsewhere, however, the quantity of bad locally generated assets seems small. Such schemes are then unnecessary. If banks are adequately recapitalised such schemes are also redundant. Similarly, if banks are adequately capitalised, concerns about mark-to-market accounting are less important, since balance sheets can cope with the needed write-downs. But it may be sensible to state explicitly that regulators will not focus only on current valuations in determining the capital requirements.
The biggest question about these proposals is whether governments can afford them. Some economists argue that many banks are not only too big to fail, but too big to save. They do so by pointing to ratios of gross bank liabilities to host-country gross domestic product (see chart). But what matters is the ratio of worst-case fiscal recapitalisation to GDP. Unfortunately, even this can be huge.
Consider the UK, where the combined assets of the big five banks is four times GDP. A recapitalisation equal to 1 per cent of their assets would cost the government an increase in debt equal to 4 per cent of GDP and a 5 per cent recapitalisation would cost 20 per cent of GDP. If any country’s banking system started to suffer losses on such a scale, debt-to-equity swaps might become inescapable. They may now be the only way forward for Iceland.
Some argue that members of the eurozone have a special challenge: individually, after all, they have no access to a central bank. The remarkable recent jumps in spreads between rates on German bunds and Italian bonds, to a peak of just under 90 basis points, suggests that markets may agree. But inflation is also a form of default. A country with a central bank, such as the UK, may well suffer higher long-term interest rates if doubt grows about its ability to finance needed bank rescues.
Yet if a recapitalisation of a substantial number of eurozone banks were needed, some member states might be unable to put up the money. There would be danger for the rest if that government chose either to do nothing or to initiate a debt-equity swap. Such actions might then raise panic everywhere. Fiscal solidarity might prove inescapable. In any case, co-ordination on how to proceed is essential if a healthy eurozone banking system is to re-emerge.
This panic is also going to have a big impact on economies. So central banks,other than the Federal Reserve, should lower interest rates. Only last week I thought a half-percentage point cut in rates made sense for the UK. If I were on the monetary policy committee today, I would argue for a full percentage point. The world has changed, greatly for the worse.
The finance ministers and central bank chiefs of the Group of Seven leading high-income countries will soon convene in Washington. For once, these are the right people. They must travel with one task in mind: restoring confidence. History will judge their success. These people may go down as the authors of another great depression. It is a destiny they must now avoid, for all our sakes.