Governments have at last thrown the world a lifeline

By Martin Wolf

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Pinn illustration

In the last week the world has seen the UK’s “good Gordon” in action. Confronted by the implosion of the country’s financial system, Gordon Brown, the British prime minister, acted. The plan his government came up with is comprehensive and bold. It will also be expensive. But the cost will be much less than the alternative – a depression – would have been.

More important, others now agree. The meetings of financial policymakers in Washington over the weekend bore fruit, first in a general communiqué and then in detailed programmes of action. The European agreement is particularly impressive. Mr Brown can rightly claim to have been the leader. The world has, as a result, stepped away from an abyss, though the road ahead remains strewn with obstacles.

Policymakers finally realised that a plan for dealing with such a severe financial crisis must contain those elements that are individually necessary and collectively sufficient. Two elements are necessary: massive provision of liquidity and recapitalisation of financially weak institutions. Two other elements will help, dependent on the circumstances: guarantees to lenders and purchases of defective assets. The US, with its complex financial system and bad mortgage assets, will find blanket guarantees hard to manage but may benefit from purchases. Europeans seem to be in the opposite situation.

The announced programmes are, in scale and construction, what is needed. Difficulties will arise in containing the distorting effects of the guarantees and arranging an exit from a partially nationalised system into one better regulated than before. But the announcements made this week, not least in the US, epicentre of the storm, should abate the panic.*

The US Treasury’s programme is, at last, suitably comprehensive. The European announcements, with promises to spend more than €1,873bn ($2,544bn, £1,479bn) are also impressive. Meanwhile, the UK has already invested £37bn in three of the country’s biggest banks.

These are extraordinary actions for extraordinary times. But will they work? Two risks remain: first, worry may shift from the creditworthiness of banks to that of governments; second, economies may weaken far more profoundly than policymakers believe. These risks are real, but containable.

Can governments afford the money they are about to spend? Yes, is my answer. Indeed, governments should be able to get all the money they are now laying out back from their banking industry. Assume the economies have a future. If so, core banking franchises will make money, as they have in the past. If banks can make money, they can repay. The task is merely one of designing the support to ensure they do.

The question of affordability is, therefore, one of fiscal credibility: if markets became sufficiently worried about the outlays, particularly at a time of large fiscal deficits, the impact on interest and exchange rates might make a default – either via inflation or even more directly – conceivable. But this still seems extremely unlikely.

In its new Global Financial Stability Report, the International Monetary Fund re-estimates losses on US loans at $425bn and mark-to-market losses on US mortgage, consumer and corporate debt at $980bn, for a total $1,405bn, up from $945bn last April (see chart). How much of this will be realised is unknown. It could be substantially less. If the economy went into a deep recession, however, it could be considerably more. But, at this point, this is “only” 10 per cent of US gross domestic product.

This is not by any means extraordinary for a big financial crisis. Moreover, close to half of these losses will fall outside the US (the joys of risk diversification!). So the total losses are now “only” 5 per cent of combined US and European GDP. A part, moreover, of the total has already been made good, by raising about $430bn in additional capital (on what mostly turned out to be catastrophic terms for shareholders).

Against this, four concerns must be registered: first, additional losses are likely on already contracted domestic European mortgage debt and as a result of the economic slowdown under way; second, countries with exceptionally large banking systems and exceptionally high domestic indebtedness may find fiscal burdens far heavier; third, the banking sector also needs extra capital, to offset the collapse of the so-called “shadow” banking sector; and, finally, the sector also needs to be substantially better capitalised.

Informed observers suggest an additional $1,500bn in capital might be needed for such reasons. So double this and assume it all comes from the state: it would still “only” be 10 per cent of US and European GDP. If the real interest rate were 2 per cent, this would be a permanent increase in public spending of 0.2 per cent of GDP. Moreover, this would not be extra demand for resources. It would be a recognition of past errors: a part of what people thought was private lending turned out to be public spending. Stuff indeed happens!

Nearly all western governments ought to be able to get away with what they are doing. But some help might have to go to weak neighbours, notably in central and eastern Europe.

Whether this relative optimism proves justified also depends on the severity of the recession. In its latest World Economic Outlook, the IMF could best be described as concerned but not apocalyptic: advanced economies are forecast to grow by 0.5 per cent in 2009, with the US on 0.1 per cent and the eurozone on 0.2 per cent; and emerging economies are forecast to grow 6.1 per cent next year, with developing Asia on 7.7 per cent. Overall, world output, at market exchange rates, is forecast to grow at 1.9 per cent in 2009, down from 2.7 per cent in 2008 and 3.7 per cent in 2007.

It is easy to tell a far worse story, with further collapses in asset prices shattering confidence and so generating big cutbacks in consumption and investment. But it is also easy to tell a better story: weakening commodity prices free central banks to pursue aggressive monetary policies, accelerating the recapitalisation of the banks, helping sustain credit and so minimising the chances of a big overshoot in asset prices on their necessary way down.

Western governments have decided to throw all their vast resources at their damaged financial sectors. A great deal of pain will still come. At some point partial nationalisation of finance must also be replaced by privatisation and better regulation. But the tide in this crisis has turned.

Comparison on financial crises

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