Column : Why aren’t things getting better?

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Why are global asset prices in doldrums even though the US has approved the $700 billion purchase of housing related securities proposed by Paulson? The crisis began as a problem for housing finance companies. But securitised home loans and derivatives thereof are all over the financial system. Once US house prices had dropped sharply, many financial firms were in trouble. But nobody knew which ones were healthy and which ones were the walking dead.

The big financial firms started mistrusting each other. This led to trouble on the ‘money market’. The money market in the West is something that we in India cannot imagine. It is a giant market where borrowing and lending through short-dated bonds takes place, including both government bonds and corporate bonds. For over 25 years, it has worked flawlessly. However, the market design of this market requires large financial firms trusting each other. Once that trust was lost, it closed shop.

Many business plans were predicated on continuous access to the money market. When the money market choked up in August 2007, financial firms which required continuous access to the money market, such as the big American investment banks, got into trouble.

At this stage, the crisis consisted of two problems. First, there was illiquidity because of the lack of a money market. Second, many firms were insolvent. For a while, governments tried dealing with one firm at a time. After Northern Rock, Bear Stearns, Lehman and AIG, they realised that the problem could not be solved in this fashion. A deeper attack was required.

Government initiative in solving the problem is justified. Once a financial panic starts, only government intervention can solve it. Once trust is lost, only governments, with the power to print money and pay off debt through future taxes, can offer credible financial guarantees, and get the financial sector to work again.