We are staring into the heart of darkness. This week will be the most crucial for the world economy in most of our lifetimes. I don’t believe this is hyperbole; the shocks dealt to the financial system have been outrunning adjectives and headlines. It is on the brink of wholesale collapse and the authorities have a very short time to come up with coordinated and credible measures to pull back from the abyss.
Stock markets around the world nose-dived on Friday, ending a nightmarish five days that saw falls on a par with those in the crash of 1929, despite the Paulson bailout plan in the US and the largely well-conceived rescue package in the UK. The mood in Washington, where the world’s policymakers have been meeting for the G-7 summit, is bleak. Their communique pledged to make public funds available to shore up banks, but if that fails there are no weapons left in the armory other than full-scale nationalizations.
Until recently, there has been a dangerous complacency about this crisis. Bank runs were things that happened long ago, or far away, in places like Latin America; the belief, from former Fed Chairman Alan Greenspan downward, was that the system could absorb shocks - as it did with the Asian banking crises, Sept. 11 and the dotcom bubble. The as yet unquantified losses from the subprime crisis will dwarf any of those and history may judge Greenspan harshly for giving markets the interest rate cuts they craved and stoking the great catastrophe we face today.
Many of us are still going about our daily business, so the magnitude of the financial crisis hasn’t sunk in. Make no mistake: It is terrifyingly real. So much so that Italian Prime Minister Silvio Berlusconi was floating the idea of shutting down world stock markets temporarily until the rules are redrafted. And so much so that small nations such as Iceland have effectively gone bust along with their banks.
Some of the most worrying insights of the past few days have been lurking deep in the back sections of the Financial Times. The market in sovereign credit default swaps - a type of insurance on governments reneging on their loans - suggests the solvency of even larger, richer nations is under strain, and that the single European currency could be at risk of disintegrating.
It now costs more to insure US government debt against default than McDonald’s, suggesting the market thinks that Uncle Sam a worse credit risk than a burger-flipping chain. In Ireland, Italy, Greece, Spain and Portugal the cost of default insurance has soared and it has risen significantly in the UK.
As the FTs Gillian Tett, one of the most prescient commentators on the credit crunch, has pointed out, there are wide divergences in the cost of insuring different countries’ debt in the euro zone. That is a huge concern because of the need for united action on recapitalizing banks and also on introducing deposit guarantees, not just for individual savers but for wholesale depositors. Politicians within the euro zone need to face the reality that larger, richer countries will need to help their smaller brethren to do this or the single currency could be jeopardized.
The post-war Bretton Woods institutions, the IMF and the World Bank, set up to restore the financial system after World War II, will have to be recalibrated to do the same after this crisis and there will have to be a powerful cross-border regulator. Central banks should not just be targeting retail prices, but asset prices, and they should ditch the discredited Greenspan doctrine that it is not their job to burst bubbles. We need better financial education in schools and better policing of the selling and advertising of financial products, so that people do not succumb again to the debt culture; the UK has a higher ratio of household debt to income than other developed economies: See chart, above left.
We also need some explanations and some show of contrition from the bankers. The more thoughtful accept that they may have to have government representatives sitting on their boards, and that they will have to accept stringent curbs on their pay.
A witchhunt against bankers might satisfy the public desire for revenge, but we need to go further. Hubris is over. Nemesis is here. Only an unsparing analysis of what went wrong will bring catharsis.
