By Charles Wyplosz

The combined central bank injection of liquidity last week was impressive. Still, more than five months after the interbank market froze, banks’ thirst for cash seems unquenchable. The central banks have done everything they can to keep financial markets orderly. They took the risk of feeding the moral hazard beast and what did they achieve? So far they have avoided the much-feared “Big Crunch”, but the end of the tunnel is not yet in sight. The time has come to ask the harder question: do commercial banks get it?

The big commercial banks hold mountains of cash, probably because they still have mountains of sickly off-balance-sheet liabilities that they are unwilling to acknowledge. Or it is because they fear that other banks are in that position and that this could trigger the Big Crunch. Or they just think that other banks think that way. Prudence is a much-needed virtue in banking, the more so because it has been forgotten in recent years.

But the further cash injection will not provide the permanent solution: the return of interbank lending. For that to happen, banks need to be reassured about each other. Recapitalisation is the only solution. Three big banks – Citibank, UBS and Morgan Stanley – have shown the way in recent days. They remind us that large losses must be financed by fresh share issuance. It matters little who provides the cash. We should not let concerns about sovereign wealth funds stand in the way of a permanent solution.

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Martin Wolf

We live in a positive-sum world economy and have done so for about two centuries. This, I believe, is why democracy has become a political norm, empires have largely vanished, legal slavery and serfdom have disappeared and measures of well-being have risen almost everywhere. What then do I mean by a positive-sum economy? It is one in which everybody can become better off. It is one in which real incomes per head are able to rise indefinitely.

How long might such a world last, and what might happen if it ends? The debate on the connected issues of climate change and energy security raises these absolutely central questions. As I argued in a previous column (“Welcome to a world of runaway energy demand”, November 14, 2007), fossilised sunlight and ideas have been the twin drivers of the world economy. So nothing less is at stake than the world we inhabit, by which I mean its political and economic, as well as physical, nature.

According to Angus Maddison, the economic historian, humanity’s average real income per head has risen 10-fold since 1820.* Increases have also occurred almost everywhere, albeit to hugely divergent extents: US incomes per head have risen 23-fold and those of Africa merely four-fold. Moreover, huge improvements have happened, despite a more than six-fold increase in the world’s population.

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Kenneth Rogoff

US Federal Reserve officials were jolted last week by the cacophony of booing that greeted their quarter-percentage-point interest rate cut. Markets badly wanted double the amount. It is part of a growing town/gown rift between a model-oriented Fed and a profit-oriented financial community.

Market commentators, including some former Federal Open Market Committee members, almost unanimously expressed deep disappointment that the Fed did not seem more attuned to the growing risk of recession. The critics were especially peeved that the Fed’s statement did not contain a clear acknowledgement that short-term growth risks easily trump short-term risks to core inflation.

The negative rhetoric cooled a bit later in the week as the big central banks announced new measures to maintain market liquidity, and as high November inflation readings made the Fed’s balance of risk assessment seem somewhat more plausible.

Nevertheless, markets remain extremely sceptical. As housing prices sink and the credit crunch grinds on, top private forecasters have been scurrying to downgrade their 2008 growth estimates.

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Willem Buiter:

On Wednesday, 12th December 2007, five central banks, the Fed, the ECB, the Bank of England, the Bank of Canada and the Swiss National Bank (SNB) are reported to have launched a coordinated attack on the North Atlantic liquidity crisis that has been with us since August 2007.  If they did engage in coordinated action, I missed it.  What I did observe was the simultaneous announcement by these five central banks of "measures designed to address elevated pressures in short-term funding markets".  Except for the timing of the announcements, no substantive coordination was involved. 

The only other bit of coordination included in the announcement was pure eye-candy - window dressing without substantive economic significance.  I am referring to the news that the ECB and the SNB have entered into currency swap arrangements with the Fed of up to $20bn and up to $4bn respectively.  The ECB will conduct repos (sale and repurchase agreements) in US dollars against the usual ECB collateral and the SNB will conduct repos in US dollars against the usual SNB collateral.

Why are these US dollar repos by the ECB and the SNB, and the associated currency swaps meaningless window dressing?  It is because, given the financial opportunities available to central banks and private financial institutions (and given the incentives motivating the latter), the economic impact of the ECB’s (up to) $20bn repo is the same as that of a repo in euro by the ECB for an amount up to the euro equivalent of $20bn, and mutatis mutandis for the economic impact of the SNB’s US dollar repo.  The reason is - and I know this will come as a shock to the central banks involved - that the US dollar, the euro and the Swiss franc are convertible currencies, for both current and capital account transactions, and that the foreign exchange markets for these currencies remain perfectly liquid, thank you very much.

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By Martin Wolf

These are historic moments for the world economy. I felt the same during the emerging market financial crises of 1997 and 1998 and the bubble in technology stocks that burst in 2000. This “credit crunch” may, I believe, be an equally important turning point for financial markets and the world economy. Why do I believe this? Let me count the ways.

First and most important, what is happening in credit markets today is a huge blow to the credibility of the Anglo-Saxon model of transactions-orientated financial capitalism. A mixture of crony capitalism and gross incompetence has been on display in the core financial markets of New York and London. From the “ninja” (no-income, no-job, no-asset) subprime lending to the placing (and favourable rating) of assets that turn out to be almost impossible to understand, value or sell, these activities have been riddled with conflicts of interest and incompetence. In the subsequent era of “revulsion”, core financial markets have seized up.

Second, these events have called into question the workability of securitised lending, at least in its current form. The argument for this change – one, I admit, I accepted – was that it would shift the risk of term-transformation (borrowing short to lend long) out of the fragile banking system on to the shoulders of those best able to bear it. What happened, instead, was the shifting of the risk on to the shoulders of those least able to understand it. What also occurred was a multiplication of leverage and term-transformation, not least through the banks’ “special investment vehicles”, which proved to be only notionally off balance sheet. What we see today, as a result, is a rapid shrinkage of markets in asset-backed paper.

The remainder of this column can be read here. Debate from our guest economists appears below.

By Fred Bergsten

The world economy faces an acute policy dilemma that, if mishandled, could bring on the mother of all monetary crises. Many dollar holders, including central banks and sovereign wealth funds as well as private investors, clearly want to diversify into other currencies. Since foreign dollar holdings total at least $20,000bn, even a modest realisation of these desires could produce a free fall of the US currency and huge disruptions to markets and the world economy. Fears of such an outcome have risen sharply in both official circles and the markets.

However, none of the countries into whose currencies the diversification would take place want to receive these inflows. The eurozone, the UK, Canada and Australia among others believe that their exchange rates are already substantially overvalued. But China and most of the other Asian countries continue to intervene heavily to keep their currencies from rising significantly. Hence, further large shifts out of the dollar could indeed push the floating currencies far above their equilibrium levels, generating new imbalances and a possibly severe slowdown in global growth.

There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund through which unwanted dollars could be converted into special drawing rights, the international money created initially by the fund in 1969 and of which $34bn-worth now exists. Such an account was worked out in great detail in 1978-1980 during an earlier bout of currency diversification and free fall of the dollar that closely resembled today’s circumstances.

The remainder of this column can be read here. Debate from our panel of economists appears below.

By Martin Wolf

The point of the story of the boy who cried wolf is that, finally, a wolf did appear. I feel the same way about the intellectual heirs of Thomas Malthus. Malthusians have finally found a wolf called climate change. Many now agree. But it is far away and coming slowly. “If the worst comes to the worst,” mutter the rich to themselves, “we can always let our children cope.”

This is the complacency that the latest Human Development Report from the United Nations Development Programme attacks. It does a good job, too. But does it do a good enough job to turn the Bali climate change conference into a call for effective action? I fear not. This is not because it fails to make a morally sound case. It is rather because humanity will change its behaviour only when convinced that the lifestyle the better off enjoy now – and the rest of the world aspires to – remains in reach.

This cynical view of human behaviour is fully consistent with what has happened so far. For it is as if the Kyoto treaty had never been. Is this judgment too harsh? Consider just a few of the many facts contained in this report: atmospheric concentrations of carbon dioxide continue to rise at a rate of 1.9 parts per million a year; over the past 10 years the annual growth rate of emissions has been 30 per cent faster than the average for the past 40 years; if the rate of emission were to rise in line with current trends, stocks of CO2 in the atmosphere might be double pre-industrial levels by 2035; and that, argues the International Panel on Climate Change, would give a likely temperature increase of 3°C, though rises of over 4.5°C cannot be excluded. If the science is right, the world is doomed to significant climate change.

The remainder of this column can be read here. Debate from our guest economists appears below.

By Daniel Gros The global economy has been hit by two shocks: the subprime lending crisis and high oil prices. The latter have faded into the background as prices have stabilised near record levels. But it would be a mistake to underestimate their importance. The recent surge in oil prices makes a rebalancing of the global economy more difficult, but it might in fact facilitate adjustment to the “subprime” credit crisis. The core of the issue is simple: oil producers tend to save about half of their windfall gains from higher oil prices. If the oil price stays around $90 a barrel, oil producers will increase their current account surpluses by $200bn-$300bn a year. The question will then be: who is willing and able to run corresponding deficits? Apart from the US, there are only two regions large enough to contemplate a shift in the external position of this order of magnitude: the eurozone and Asia (Japan and China).

The remainder of this column can be read here. Debate from our guest economists appears in the comments below.