Unfreeze the interbank markets by guaranteeing interbank lending

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.

The only quasi-fiscal resource available to the ECB and the Eurosystem is seigniorage – the ability to extract real resources through the issuance of fiat money. The ECB and the Eurosystem are, by Treaty, forbidden from imposing that quasi-fiscal tax if it threatens price stability. The ECB and the Eurosystem therefore can only provide financial support when the problem is illiquidity rather than insolvency. In much of the euro area, the banking system is now threatened by insolvency. This means that only the true fiscal authorities, that is, the national governments capable of raising taxes and cutting public spending, can step up to fill the banking system’s solvency gap.

With a series of bold moves, and the promise of more to come should more be needed, the UK authorities have, for the first time since this global financial crisis started in August 2007, got ahead of the game and put themselves in a position to shape events rather than just respond to them. The leading contintental European nations are in denial about the gravity of the situation, despite the warnings provided by the collapse of Fortis and Dexia. The US authorities hope/pray that the $700 billion TARP facility will do the job. It won’t. Even if it is used in its entirety to recapitalise the US banking system, it will only fill a small fraction of the solvency gap.

Large-scale fiscally financed injections of capital into the bankings systems of the US and the EU (sans UK) are required immediately. Where border-crossing banks are involved, fiscal burden-sharing formulae will have to be designed. This is impossible if the political will is absent; it is a trivial task if the political will is there.

In addition, there is an urgent need for direct interventions in the financial markets, targeted directly at the blockages/distortions preventing these markets from functioning. That means either unsecured lending by the central bank to the banks (i.e. the central bank interposing itself as counterparty of last resort in the interbank market) or Treasury guarantees of interbank transactions.

The banks participating in the interbank markets are inherently border-crossing institutions. Only if all EU members, the EU orphans (Switzerland, Norway, Iceland), the US, Japan and Canada decide on a common approach to getting interbank lending going again is there a realistic chance of success.

It is time for the continental European governments and for the US authorities to stop hoping for a miracle. When the going gets tough, only fiscal solutions will do. When systemically important markets fail comprehensively, only the coercive power of the state, backed by taxation and regulation – the power to prescribe and proscribe – offers a way out. Politics now drives economics. I hope our political class is up to the job.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website