Opinion
The financial crisis: where next?
By George Irvin
It's been a momentous and contradictory ten days. The US $700bn bailout deal last week, far from steadying the financial markets, sent them into further spasms. This week, the contagion spread to Europe where first Ireland, then Greece, Germany and other countries attempted to calm the panic by guaranteeing investors' savings.
The fear of further bank runs meant that unilateral action by member states trumped a co-ordinated response at EU level, undermining President Sarkozy's Paris summit.
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Meanwhile, Britain's dithering caused the FT-100 to plunge, provoking Prime Minister Brown's government into partially nationalising the banking sector and delivering a huge cash injection - a total of €630 billion (£500bn), greater than even the Paulson bail-out.
As for smaller countries outside the EU, Iceland provided a stark lesson of the devastating cost of running your country like a giant hedge fund without the protective mantle of the euro.
Where do we go from here? Are markets in for a period of calm, or will the roller coaster ride continue unabated despite the bailouts and interest rate cuts. Nobody knows the answer, but most agree that even if markets regain a degree of composure, it's only a matter of time before further storms break out.
Further storms
There are three reasons why the problems of the financial sector will be with us for some time to come. First, there's the herd instinct. When many investors run for cover, it can quickly become a stampede ending who knows where.
Second, by providing 100 percent insurance to savers, Germany and other countries may have averted a possible run on retail banks (i.e., on high street banks). But investment banks and other institutions such as hedge funds (often owned by investment banks) don't get their funds from savers, but from the money market, the so-called wholesale sector.
Reassuring small savers and the retail sector is insufficient to kick-start banks lending to each other again.
Of course, governments can help mitigate the drying up of inter-bank lending by pouring their own money into the system, in other words by offering credit to the markets through central banks. But what is needed to restore the health of the banks is a bail-out of non-performing assets. This is in essence what Mr Paulson has tried to do in the United States. And recapitalisation, as we know, can be a very expensive business.
Moreover, where government fails to take an active role in management, restoring the health of a bank's balance sheet does not guarantee that it will start lending again, particularly if other banks are still shaky. In short, although governments can help restore balance sheets and provide massive credit injections, getting financial markets running smoothly again is more likely to take years than months.
Financial plus economic crisis = depression?
The most serious problem, though, is that Europe and the USA face not just a financial crisis but a major economic crisis.
New official statistics appear every day telling us that consumer demand is weakening, order books are slack and unemployment is rising.
It is the coincidence of continued global financial crisis and recession in the real economy which makes the current situation so dangerous; indeed, it is precisely this combination - together with wrong headed government policies - which can turn a recession into a depression.
The unscheduled and co-ordinated interest rate cut by the Fed, the ECB and other central banks is greatly to be welcomed. Nevertheless, there must be further cuts. In 1989, Japan waited 18 months before cutting real interest rates to zero with costly results. This time around, we are already a year into the crisis.
Medicine required
Four further elements are crucial in any rescue package. These are: fiscal policy, regulation and co-ordination, ending tax secrecy and improved governance.
Loosening monetary policy is a necessary but non-sufficient condition for recovery. Because of the 'liqudity trap' problem, it must be accompanied by fiscal expansion.
Again, the experience of the USA during the Great Depression and of Japan in the 1990s is instructive. In both cases, it took more than merely large scale public investment to get the economy moving, mainly because the general price level was already falling by the time these were attempted.
Today, the US fiscal deficit is headed towards four percent and public debt 65 percent of GDP, so there is less room for fiscal expansion than there was, say, after the collapse of the dot-com bubble in 2001. Crucially, in contrast to the EU, the US runs an enormous external deficit.
European fiscal policy
Europe has more room to reflate than the USA. Sadly, though, the Union has no collective provision for counter-cyclical fiscal policy, and member-states are shackled by the Stability and Growth Pact, (SGP).
Given the prospect of long-term recession, the SGP should be scrapped and the Union's budget thoroughly reformed. As I have argued in earlier pieces, unless Europeans recognise the need for sound political and economic co-operation at community level, the euro itself will be under threat.
Union-wide Regulation
Regarding regulation of the financial sector, everybody agrees that something must be done, although nobody knows quite what. A European version of Glass-Steagall would be a start, delivering a clear separation between high street banks and their (largely unregulated) investment counterparts. Ironically, European financial supervision is probably still weaker than it was in the US a year ago.
Secrecy and Tax evasion
One critical weakness in Europe is lack of action on offshore financial centres, the 'black holes' that banks and other institutions use in order to mask their dodgier operations and minimise tax liability. Brussels has taken positive steps - for example, the EU tax directive slapping a withholding tax on monies banked offshore. But what is required is strong laws to crack down on tax havens and harmonise company taxation across the Union. Europe can simply no longer afford to allow member states to compete in providing safe havens for embezzlement.
Good governance
Much is written about the need for 'good governance' in the developing world, while here in the rich countries we have allowed financial managers to gamble with millions and pay themselves outlandish rewards. To make matters worse, it is proposed to recapitalise the system at the expense of the taxpayer.
One could of course argue that 'social Europe' should fully nationalise its financial sector. But under current political conditions, it would be unrealistic to expect such a proposal to gain much traction.
Here is a simple alternative. First, politically, either elected trade union or government representatives should be placed on the board of every bank, thus injecting a much needed dose of democratic accountability into the sector; such representatives would also have a major say about executive remuneration.
Second, at an economic level, all financial institutions (whether partially government-owned or not) should be required to have an annual share issue of one to two percent of total equity capital, the proceeds of which would go to a public trust fund.
The advantage of such an arrangement is that, although marginally diluting share value, it would not cut into an institution's cash flow. The fund would be used to help pay for the damage which this crisis has caused and used to, say, build affordable housing, guarantee mortgages and the like.
The general public is angry about what has happened and will become even angrier if it is made to bear the full cost of the crisis. The time has come for politicians to heed the call for solutions based on fundamental reforms, and not simply to pour good money after bad.
The author is Professorial Research Fellow at the University of London, SOAS
Disclaimer
The views expressed in this opinion piece are the author's, not those of EUobserver.