The content of coordination

Barry Eichengreen 09 October 2008

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If the events of the last week have a silver lining, it is that they have driven home the fact that we are all in this together. The crisis is global. We will sink or swim together. The hurried decision of G7/8 finance ministers to meet in Washington on Friday is belated recognition of this fact.

But one thing we have learned from recent unsuccessful attempts to right the ship is that empty words of reassurance are not enough. Indeed they can be counterproductive if not accompanied by deeds. Seeing only empty words, market participants will conclude that national leaders cannot agree on what is to be done. And the downward spiral will accelerate.

This is the danger that may arise when G7/8 leaders issue a communiqué later this week on their coordinated response to the crisis. If they simply say, “we will work together to unclog credit markets and restart the interbank market,” they will only be repeating the obvious. Their empty platitudes will further demoralise the markets.

So on what specific actions should they agree? The priority should be a coordinated programme to immediately recapitalise banking systems. The UK has shown how this can be done in a matter of days. But there is an urgent need for the G7 countries, together with the other Europeans, to immediately implement an analogous plan. Failing that, the problem will only be shifted, not solved. Now that British banks are stronger, funding will flow there from other countries. The UK’s unilateral recapitalisation of its banks is superior to Ireland’s unilateral guarantee of all bank deposits in that it addresses the root causes of the current problem and not simply its symptoms. But it creates the same beggar-thy-neighbour dangers.

In addition, in the case of cross-border banks there is the question of whose taxpayers should bear the burden of recapitalising them. This creates a dangerous free-rider problem that urgently needs to be addressed. But as our friends in Iceland will remind us, the issue goes beyond fairness to taxpayers. It goes to the capacity of the state in cases like UBS and Credit Suisse, whose assets are both substantial multiples of Swiss GDP. Even if countries like Switzerland try to do something, the fiscal implications may be so alarming that investors flee. The capital that the government pours in through the top of the jar may then just leak back out through these holes in the bottom. This is essentially what brought down the Austrian and German banking systems when those countries were denied foreign help in 1931.

As Fortis and Dexia have shown, burden sharing is not an insurmountable problem, but the need for it should be addressed explicitly in the communiqué announcing the joint recapitalisation scheme. And to assist countries for whom even a share of the burden may be too heavy, the IMF should be instructed to announce a special low-cost lending facility making available funds for the specific purpose of bank recapitalisation. Switzerland, Sweden, Iceland, and Korea may be among the first customers when the markets reopen on Monday.

While the UK has supplied the blueprint, the US must provide the leadership. The Paulson Plan, everyone now agrees, failed to reassure the markets because it did not directly and credibly address the need for bank recapitalisation. Recapitalising the banks without taking an equity stake would have required overpaying for bank assets, and this is not something that a Congress facing a general election in three weeks was prepared to allow – quite reasonably on its part. Moreover, by the time US Treasury assembles its team of rocket scientists and designs an efficient set of auctions, the financial system and economy will have suffered yet more financial damage. We cannot wait for the next administration. We cannot even wait for this administration to call the Congress back into session in order to hold hearings on Plan B.

The Bush administration should therefore abandon the idea of buying toxic assets. It should use the wiggle room under the TARP, which includes language about equity warrants, to directly inject capital into the banks. Done expeditiously – tomorrow – this may require less than the full $700 billion. But notice the weasel word “may.” Even if the US follows with British-style alacrity, scaling up the British plan still implies injecting $500 billion of new capital. Either way there is no reason to waste money on incidentals like reverse auctions. And US participation is critical to the success of and even agreement on an internationally coordinated bank recapitalisation plan.

These measures will have to be supplemented with others. Regulators will have to immediately seize insolvent financial institutions to prevent them from gambling away taxpayer funds. The need for such steps is coming in any case. Their pace will now have to be stepped up.

To be sure, there will be political hell to pay. There will be a firestorm of criticism that Secretary Paulson is running roughshod over the separation of powers and putting taxpayer money at risk. The last time we had a financial crisis of this magnitude, Franklin Delano Roosevelt shut down the banking system, took the country off the gold standard, and abrogated the gold clauses in private contracts, all in a matter of days. He was target of vituperation. But he exercised what we call leadership. It is not too late to see if there is a repository of the same left in the United States.

There are other creative ideas out there. Central banks could cut another 50 basis points. They could guarantee interbank deposits. They could emulate the Fed in putting a floor under the price of other unsecured paper. But central banks have pushed pretty much as hard as they can on the available strings. This is now a problem for governments and their treasuries. It is the latter who now urgently need to coordinate concrete steps.

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Topics:  Financial markets

Tags:  rescuing jobs and savings