The G-7 have done the absolute minimum required not to have their Washington DC meeting on Friday, October 1o characterized as an abject failure. So let’s just call it a disappointment and a missed opportunity. There was, unfortunately too much of the “we will use all available tools” verbiage (the G-7 variant of the British “we will do whatever it takes”) and not enough commitment to concrete, specific schemes and firm actions that leverage international cooperation to address the global financial crisis.
Each country is now supposed to outline its commitment to take specific action to support liquidity in key financial markets (such as the interbank markets, markets for commercial paper, for asset-backed commercial paper and for mortgage-backed securities), bank recapitalisation, funding for the financial system and deposit guarantees.
It is impossible to be confident about the future development of market confidence. But the continuing mayhem in global equity markets and in most other systemically important financial markets, the fear and mistrust that have caused the banks to stop lending to each other and the growing sense of doom about the outlook for the real economy all suggest that without further radical policy measures we are unlikely to escape from the downward spiral sucking the world economy towards a re-run of the 1930s.
Lack of confidence in the viability of banks and other institutions with bank-like features, including high (embedded) leverage like AIG and other insurance companies is a key obstacle to a resumption of normal financial intermediation.
Gordon Brown is absolutely right in his proposal that the G7 offer state guarantees, on ‘commercial’ terms (really terms that provide the state with an adequate risk-adjusted return on the funds it commits) to restore life to interbank lending. Banks today don’t lend to each other without high-grade security at any but the shortest maturities. When banks don’t lend to each other, they don’t lend to the real economy – non-financial businesses and households. That is the road to economic disaster.
If French officialdom believes the interbank lending market in the eurozone to be in materially better shape than in the UK, it is detached from reality. In addition, the euro area member states, the rest of the EU member states and indeed the US are well behind the UK as regards putting in place the fiscal underpinnings for the survival of their banking sectors. The notion that the ECB and the rest of the Eurosystem can play the role that is played in the UK by the fiscal authority, is a dangerous delusion.
Early in 2008, Anne Sibert and I were asked by the Icelandic bank Landsbanki (now in receivership) to write a paper on the causes of the financial problems faced by Iceland and its banks, and on the available policy options. We sent the paper to the bank towards the end of April 2008. On July 11, 2008, we presented a slightly updated version of the paper in Reykjavik in front of an audience of economists from the central bank, the ministry of finance the private sector the academic community. A link to that paper can be found here.
Because our Icelandic interlocutors considered the paper to be too market sensitive, we agreed not to put it in the public domain. Now that all three formerly internationally active Icelandic banks – Glitnir, Landsbanki and Kaupthing - have gone into receivership, there is no reason not to circulate the paper more widely, as some of its lessons have wider relevance.
Our main point was that Iceland’s banking sector, and indeed Iceland, had an unsustainable business model. The country could retain its internationally active banking sector, but that would require it to give up its own currency, the Icelandic kroner, and to seek membership of the European Union to become a full member of the Economic and Monetary Union and adopt the euro as its currency. Alternatively, it could retain its currency, in which case it would have to move its internationally active banking sector abroad. It could not have an internationally active banking sector and retain its own currency.
Today, the US Federal Reserve, the European Central Bank, the Bank of England, the Bank of Canada, the Swedish Riksbank, the National Bank of Switzerland and the monetary authority of the United Arab Emirates all cut their official policy rates by 50 basis points. The People’s Bank of China cut its one-year benchmark lending and deposit rates by 27 basis points. I had been hoping for (and had called for) a coordinated rate cut, but had not expected anything of this scope. It is timely, necessary and most welcome. The fact that the Chinese monetary authority and a key GCC monetary authority participated is of great symbolic significance and marks the accelerating shift of global financial and economic clout to the Far East and the Middle East. But the contribution of the rate cuts to ending the confidence crisis is dwarfed by the actions that have been taken or will soon be taken, by the fiscal authorities in the North Atlantic area.
A government should only nationalise a bank (let alone most of its banking sector) if it has the fiscal strength to support the bank (or its banking sector). If it does not have the fiscal resources, now and in the future, to restore the banks to solvency, a private sector insolvency problem is transformed into a government insolvency problem. On the whole, the consequences of state default are more serious for the residents of a country than the consequences of a private bank default.
If the banks in question have a large amount of foreign currency debt, maintaining government solvency when the government tries to make all the banks’ creditors whole, requires two distinct resource transfers: an internal fiscal transfer, through spending cuts or tax increases from the domestic private sector to the government, and an external transfer through a larger primary surplus in the balance of payments accounts. Such an external transfer generally requires a depreciation of the real exchange rate and a worsening of the country’s external terms of trade.
Iceland is a rich country, but it has just 300,000 inhabitants (like Coventry in the UK). It does not have the fiscal resource base to support a credible nationalisation of its banking sector, unless it is willing and able to securitise the future revenues from its hydro- and geo-thermal power resources (something Anne Sibert and I recommended last April). Apparently, the government is not willing to do that.
The government of Iceland is using the threat of a €4 bn loan from Russia in exchange for a 99-year lease on the airport at Keflavik – a former American air base – as leverage to obtain financial support from the West. This is high-stakes poker -not without risk to Iceland, if their bluff is called. I would have securitised the future revenues from hydro and geo-thermal power generation before bringing on the Red Army. It does show, however, that there may be more collateralisable assets around for governments to draw on than one might have thought. Good news for Chancellor Darling.
It is time for Ministers of Finance, Chancellors of the Exchequer and Secretaries of the Treasury to act to recapitalise the tottering banking systems of the North Atlantic region. Statements that “we shall do whatever it takes to safeguard the banking system of (fill in name of country)” don’t cut it any more. The banks with border-crossing activities in the US, the UK and continental Europe are now all at risk of failing. They are all cutting back drastically on their lending to the real economy. Official dithering is exacting a growing price, to be paid by tax payers and the future unemployed.
It’s reasonable to assume that the banking system in the North Atlantic region is insolvent and would be bankrupt but for the reality of recent government bailouts and the expectation of future government bailouts. Certainly, for the system as a whole, the marked-to-market value of its assets is way below that of its liabilities. I strongly suspect that even the hold-to-maturity value of its assets is well below that of its liabilities. Although the system as a whole is broke, there are no doubt individual banks that are solvent. We may not, however be certain as to which banks are solvent and which banks are not.
I also take it is given that it is desirable – essential even – to preserve the core of the banking system and to keep it operating without interruption, because it fulfills an essential role in the intermediation of funds between financial surplus units and financial deficit units – a role for which no substitute can be found or created in the short and medium term. The bulk of the banking system therefore needs to be bailed out. In practice this means that most of the large banks need to be bailed out in the first instance. Consolidation through mergers, acquisitions or liquidations will mostly have to wait until order has been restored in the global financial markets.
The main remaining question then becomes who will pay for the bail out, the tax payers or the existing creditors of the banks (including the shareholders and other providers of equity). I have a strong preference for putting much of the cost of a bailout on the existing creditors. This is in part for reasons of equity and fairness: the existing creditors made bad investments/loans; they ought to pay for their failures. They earned a risk premium while the going was good. They ought to eat the risk when it materialises. It is also for incentive reasons. Future lending to banks and future purchases of bank obligations will be undertaken with a better appreciation of the credit risk involved. Another massive over-expansion of the banking sector will be less likely.