he credit crunch

World on the edge

Oct 2nd 2008
From The Economist print edition

Whatever happens in Congress, the crisis is now global; that means governments must work together

AMERICA’S Congress is not used to being second-guessed. But as lawmakers wrestled in the Capitol, world stockmarkets have been giving real-time odds on the Bush administration’s $700 billion bail-out becoming law. After the plan’s thrashing by the House of Representatives on September 29th, spurred on by voters’ loathing of “casino capitalism”, investors panicked. Yet as The Economist went to press, they were optimistic that, after winning the Senate’s approval on October 1st, the plan would pass.

Even if it does, that should not be a cause for optimism. Look beyond the stockmarkets, especially at the seized-up money markets, and there is little to see except bank failures, emergency rescues and high anxiety in the credit markets. These forces are drawing the financial system closer to disaster and the rich world to the edge of a nasty recession (see article). The bail-out package should mitigate the problems, but it will not avert them.

The crisis is spreading in two directions—across the Atlantic to Europe, and out of the financial markets into the real economy. Governments have been dealing with it disaster by disaster. They have struggled to gain control not just because of the speed of contagion but also because policymakers, and the public they serve, have failed fully to grasp the breadth and depth of the crisis.

What’s the Icelandic for “domino”?

Step forward, Peer Steinbrück, Germany’s finance minister, who rashly declared on September 25th that America was “the source…and the focus of the crisis”, before heralding the end of its role as the financial superpower. Within days, the focus shifted and Mr Steinbrück and his officials were obliged to arrange a €35 billion ($51 billion) loan from German banks and the German government to save Hypo Real Estate, the country’s second-biggest property lender.

The hapless Mr Steinbrück is not alone. European banks were collapsing at a dizzying pace even as Christian Noyer, governor of the Bank of France, declared that “there is no drama in front of us.” Hypo Real Estate was just one of five banks in seven European countries bailed out in three days. Belgium, Luxembourg and the Netherlands carved up Fortis, a big bancassurer; Britain nationalised Bradford & Bingley; Belgium, France and Luxembourg saved Dexia; and Iceland rescued Glitnir. Separately, Ireland took €400 billion of contingent liabilities onto the national balance sheet, when it stood behind the deposits and debts of its six large banks and building societies. You have to wonder what Mr Noyer regards as dramatic.

By some measures, many European banks look more vulnerable than their American counterparts do—and that is saying quite something, given the past week’s forced sale of Washington Mutual, America’s biggest thrift, and Wachovia, its fourth-biggest commercial bank. In America, outside Wall Street, the banks have lent 96 cents for each $1 of deposits. Continental European banks have lent roughly €1.40 for each €1 of deposits. They have to borrow the rest from money-market investors, who are not especially confident just now. Some Europeans, including the British, Irish and Spanish banks, have housing busts of their own. And they must contend with the toxic American securities they bought by the billion, as well as their own slowing economies.

Western Europe is not the limit of this: the panic has also struck banks in Hong Kong, Russia and now India. And it is not just the geographical breadth of this crisis that is alarming, but also its economic depth. Because it is rooted in the money markets (see article and article), it will feed through to businesses and households in every economy it hits.

Take a deep breath

Most of the time nobody notices the credit flowing through the lungs of the economy, any more than people notice the air they breathe. But everyone knows when credit stops circulating freely through markets to banks, businesses and consumers. For almost a year the markets had worried about banks’ liquidity and solvency. After the bankruptcy of Lehman Brothers last month, amid confusion about whom the state would save and on what terms, they panicked. The markets for three-, six- and 12-month paper are shut, so banks must borrow even more money overnight than usual.

Banks used to borrow from each other at about 0.08 percentage points above official rates; on September 30th they paid more than four percentage points more. In one auction to get dollar funds overnight from the European Central Bank, banks were prepared to pay interest of 11%, five times the pre-crisis rate. Astonishingly, rates scaled these extremes even as the Federal Reserve promised $620 billion of extra funding.

Bankers have always earned their crust by committing money for long periods and financing that with short-term deposits and borrowing. Today, that model has warped into self-parody: many of the banks’ assets are unsellable even as they have to return to the market each day to ask for lenders to vote on their survival. No wonder they are hoarding cash.

This is why those politicians who set the interests of Main Street against those of Wall Street are so wrong. Sooner or later the money markets affect every business. Companies face higher interest charges and the fear that they may one day lose access to bank loans altogether. So they, too, hoard cash, cancelling acquisitions and investments, in order to pay down debt. Managers delay new products, leave factories unbuilt, pull the plug on loss-making divisions, and cut costs and jobs. Carmakers and other manufacturers will no longer extend credit (see article) and loans will become elusive and expensive. Consumers will suffer. Unemployment will rise. Even if the credit markets work well, the rich economies will slow as the asset-price bubble pops. If credit is choked off, that slowdown could turn into a deep recession.

Financial markets need governments to set rules for them; and when markets fail, governments are often best placed to get them going again. That’s pragmatism, not socialism. Helping bankers is not an end in itself. If the government could save the credit markets without bailing out the bankers, it should do so. But it cannot. Main Street needs Wall Street; and both need Washington. Politicians—and President George Bush is the most culpable among them (see article)—have failed to explain this.

Governments need not just to communicate, but also to co-ordinate. Past banking crises show that late, piecemeal rescues cost more and work less well. Ad hoc mergers work for a while, but demands for help tend to recur. Inconsistency sows uncertainty. Cross-border banking can make one country’s policies awkward for the neighbours: the Irish government’s guarantee of all deposits threatens to suck in money from poorly protected British banks. France’s suggestion on October 1st that Europe’s governments should work together was a good one; Germany’s rejection of it was wrong.

Central banks have co-ordinated their liquidity operations. Now that oil prices have plunged and worries about inflation are receding, interest-rate cuts are possible. They would be more powerful if co-ordinated. But it is not only central banks that need to combine. Whatever America’s Congress does, governments should work together on principles to stabilise and recapitalise banks—not just to stem panic but also to save money. Even if, as the Europeans claim, the crisis was made in America, it now belongs to everyone.