I am writing this from Washington DC as dawn creeps up over grey brick buildings. In global financial markets, the darkest hour is also passing. In May I wrote to you that a crash was coming and that you should leave the stock markets until October, St Ledgers Day, to be precise, which was last Friday. I wavered a little in August but could not see a major recovery. Today I am less pessimistic than I have been for six months. Not because of the old City of London folklore to “sell in May and buy again on St Ledger’s day”, but because of two things that have occurred in the past few days.
The first reason for my declining pessimism is that western policy makers have united in saying at the end of the G7 meeting here in Washington on Friday, October 9, that they will “do whatever it takes” to end the market panic. The financial markets were initially unconvinced by that statement. It lacked specifics and detail. But if such a comprehensive statement is followed up by big initiatives, as has been the case in Paris on Sunday, October 12, then it creates risks for investors to short the market or even to be out of the market. Most of the returns of stock markets are concentrated over a small number of days—miss those days and it is hard to catch up.
Secondly, there is an emerging consensus over what needs to be done to end the financial panic. There are three things that need to be done to revive the credit markets that are currently frozen. The first is for governments to guarantee short-term transactions between banks. This would revive the interbank market. The death of this market, as banks became suspicious of other banks’ ability to survive the panic, forced all banks to hoard liquidity and curb lending. This only made things worse. The British adopted guarantees for the interbank market a week ago and at the Sunday meeting of European Union leaders in Paris, the EU adopted this more widely. European markets will benefit and the spotlight is on the US policy makers to respond.
The second thing governments need to do is to raise capital at banks by buying preference shares or other forms of equity. Eighteen months of write downs have pushed bank capital—the buffer between the value of what they own and the value of what they owe—to wafer thin levels. If this continues, most US and European banks would be insolvent on a mark-to-market basis. As a result of the rescue of Fortis bank in the Netherlands, HBOS and RBS in the UK, and others elsewhere, European governments have stumbled on to this approach. US Treasury Secretary Paulson now says that the $700bn Troubled Asset Relief Program (TARP) will now be allowed to buy shares in troubled banks.
The third requirement is for governments to encourage the creation of long-term capital pools to buy assets on a commercial basis, but with a long-term objective, unconcerned about short-term mark-to-market volatility. This would lift the price of credit instruments back towards a measure of the underlying risk of a default, and not just a measure of the risk that these instruments cannot be sold tomorrow. Rising credit prices will make bank balance sheets healthier and reduce the spiral of distressed selling of assets. There has been least progress on this front, though to some extent this is what the US TARP could be made to be. I would prefer something where governments are less directly involved and where the objectives are more narrowly commercial. I would capitalise long-term insurance and pension funds on the basis that they will create portfolios of credit instruments. But in a crisis there is little time for niceties.
Ending the panic will not end our economic problems. We would be faced with two challenges immediately. First, while bankers have proved to be not very good at banking, I doubt governments will be much better. With the massive nationalisation of the western banking system as a result of previous over-lending, banks are likely to be extremely risk averse. Credit will be constrained and economies will slow. Think of the irony of the Indian banking system having less government involvement than the British banking system! If 2008 was the year of global financial panic, 2009 will be the year of global economic stress. Second, we have learned that national tax payers are the ultimate guarantee of any banking system. This casts a shadow over cross-border banking—something that has fuelled globalisation more generally. There will be those who think this is a good thing. There are tough times ahead for the global economy, but at least we have now entered the beginning of the end of the market panic of 2008.
—The author is chairman of London-based Intelligence Capital, governor of the London School of Economics and Emeritus Professor of Gresham College in the UK