An abbreviated version of Wolf’s Wednesday column*:
As John Maynard Keynes is alleged to have said: “When the facts change, I change my mind….” 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 piecemeal approach to the crisis 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 prompted some governments to provide full or partial guarantees of liabilities. Such guarantees distort competition but once granted, cannot be withdrawn until the crisis is over.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.
The second priority is recapitalisation – essential if institutions are to be deemed creditworthy after the guarantees are withdrawn.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.
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. Elsewhere, however, the quantity of bad locally-generated assets seems small – rendering such schemes unnecessary and, if if banks are adequately recapitalised, 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.
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. But what matters is the ratio of worst-case fiscal recapitalisation to GDP. Unfortunately, even this can be huge. 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.
When G7 finance ministers and central bank chiefs convene soon in Washington they must have 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.
Full text here