The massive and reasonably well coordinated bailouts undertaken in a large number of countries should eventually bring the financial crisis to its unhappy end. There may be more hiccups and the need for more intervention – and more money – but the British plan has offered a good blueprint. The original Paulson plan sought to relieve banks from their toxic assets, but it never quite managed to find a good way to price them. Instead of attempting to shore up the asset side of bank balance sheets, the British plan focuses instead on the liability side. By undertaking to guarantee bank borrowings, it lays the ground for a restart of the money market. By further offering to inject capital, the plan kickstarts the process of reconstruction of badly damaged banks. It could well be the final best plan combines both.
The success of the plan depends on the willingness of banks to play the game and apply for support. Some will not, because they believe, rightly or wrongly, that they don’t need it. Another reason for them to turn the plan down is that, in some countries, it includes capping bonuses and suppressing dividend payments, thus creating an unholy alliance between managers and shareholders. It would be very problematic if several major banks elect to stay out of the plan, for it would create a stigmatization effect. If some banks claim that they do not need help, those which do may hesitate for fear of being branded as fragile, or mismanaged, or both. That could undermine the whole plan. This is a serious threat in Germany.
With the increasing willingness of central banks to absorb assets of dubious quality – in effect implementing the Paulson plan – we now have a fairly exhaustive bailout in place. If, somehow, most banks buy into it, the virulent phase of the financial crisis should come to an end. This will usher another phase, the picking up of its consequences. We will need to think about better financial market regulation, but the immediate concern is growth. Over the last month, forecasts have turned decisively somber. The slowdown so far has been driven mainly by the surge in oil and commodity prices that took place last year. The effects of the financial crisis have barely started to be felt. Here the worse is clearly in front of us. For several years, the financial markets marveled at their huge “risk appetite”. This flawed concept really combined risk aversion and perceived risk. Risk aversion has probably never changed. What did change was the perception that risk was low. Financiers seem to have believed that they could combine high returns and low risk. That was never possible, as they painfully discovered. They were amassing the huge risks that go hand in hand with huge profits, but they considered risks to be low. Now we hear about low risk appetite. Once again, the same mistake is being made. Exactly as they were underestimating risks, banks now massively overestimate them. As a result, we face a credit crunch. If banks do not act as banks, that is if they do not grant loans to trusted customers, the economy cannot grow. In fact it can only contract. We face a real self-fulfilling prophecy: banks stop making loans because they consider all borrowers to be unreliable, which will prompt bankruptcies and payment defaults and thus validate ex post the bankers’ fears. In response to this major threat, the Fed has started to act as a commercial bank and grant loans to the private sector. In France, the bailout plan includes a clause that requires banks to lend as much as they did last year. Clearly, neither response will substitute for a working banking system. This is why a credit crunch is inescapable and why economic forecasts are gloomy. This may be why stock markets are so volatile, but then wisdom has never been one of their attributes. Their collective ability to switch in no time from depression to exuberance – a syndrome called bipolarity – is proverbial.
On the other hand, the abrupt decline in oil and commodity prices will be of great help to cushion the upcoming blow. It may be a mixed blessing, though. It will help bring inflation down. But, with growth stalling, inflation may fall too much. Deflation is not ruled out anymore. Deflation is a terrifying threat. It encourages people to postpone discretionary spending, which deepens the recession and further pushes price down in a very vicious cycle. It raises the real value of debts, thus pushing previously solvent borrowers into bankruptcy, adding a new blow to the financial system. It knocks off monetary policy once interest rates reach the zero lower bound.
This is why the authorities, which did so much to hopefully bring the financial crisis to its end, have much more to do. Monetary policy may not be very effective in the presence of a credit crunch, but central banks have little choice but to promptly bring interest rates down, very far down. But monetary policy alone will not take us out of the wood. Governments must act quickly and decisively. They have no choice but to adopt sharply expansionary fiscal policies. It is all too easy to anticipate objections. Some will argue that fiscal policy does not work, which is simply wrong. Others will say that public debts are too large to be allowed to grow again. Wrong again. If we go into a recession, deficits will grow anyway. If we go into deflation, debts will grow even without deficits. Fiscal discipline is a fundamental attribute of good government, but now is not the time to enforce it. Preventing misery to afflict millions of hapless citizens is not just a higher order of priority. It is a necessity if we are to avoid a deeply disoriented public opinion from believing in one form or another of populism and its simplistic solutions.
It is now commonplace to call this financial crisis the worst ever. This is probably true, and enough to sap the spirits of the most optimists amongst us. But there is good news too. Since the beginning of the crisis in August 2007, the authorities have displayed an amazing ability to innovate. The solutions adopted recently were simply unimaginable a month ago. And the same can be said about the measures adopted a month ago. And so on all the way back to August 2007. The authorities obviously use a lot of what we have learned in countless financial crises. They do so with creativity and, often, surprising boldness. This is why we stand a very good chance of escaping a remake of the 1930s. But if you want to worry, here is a final thought. Many of the measures put in place by the authorities are new, and therefore untested. Unavoidably, some mistakes are being made, whose consequences will be revealed later. It is difficult not to think that some sword is hanging above our necks. Well, still, don’t despair.
Originally published at Finanz Und Wirtschaft and reproduced at Charles Wyplosz’s website and reproduced here with the author’s permission.