September 18, 2008 3:00 am
After the US Treasury secretary Hank Paulson's brave stand on "moral hazard" at the weekend, it took less than 48 hours for pragmatism to prevail over principle in the form of a government rescue for the ailing insurer AIG. For all the hand-wringing of the "no bail-out" proponents, the takeover was almost certainly necessary, given the potential for significant contagion via the unwinding of complex counterparty exposures.
With the demise of AIG, the markets' verdict has been rendered: a reactive, ad hoc, mostly private sector approach to the challenges of the financial sector will not work. The problems are systemic and the remedies need to be comprehensive. The challenges - including a shortage of capital, dysfunctional wholesale credit markets, widespread deleveraging and significant asset sales - are too large, too widespread and too complex to be managed by the private sector alone.
US and European financial institutions do not have the capital or balance sheet strength to offset the downdraught of falling asset values. Those with capital are unwilling to subsidise those without, at least not at prevailing prices. Put differently, if a (quasi) private sector solution was in the offing this past weekend, then Mr Paulson and Timothy Geithner, president of the Federal Reserve Bank of New York, invited the wrong financiers. The only sources of capital large enough to address the problems reside in Asia or the Middle East, not New York or London.
And that speaks volumes about the future of global finance.
Practically speaking, the only balance sheet capable of absorbing the deleveraging is the US government one. Understandably, Mr Paulson has been reluctant to put more taxpayers' money at risk. But, as the events of the past two days demonstrate, he has had little choice. Moreover, the sharp fall in commodity prices is a clear sign that the tumult in the markets is expected to drag down an already weak global economy.
What, then, are, the basic contours of a comprehensive financial sector strategy?
* The stigma on government involvement should be jettisoned. Government intervention has precedence and can help stabilise the system. That is true of emergency liquidity provision or the relaxation of collateral rules by central banks. But it is equally true of efforts to promote consolidation, capital injection and ownership change in the banking sector.
* Central banks should ease monetary policy. Falling commodity prices, the likelihood of falling inflation and the reality of sharply slowing global growth demonstrate the need for concerted global easing .
* As the Financial Stability Forum recently noted, banks and other financial institutions will have to raise at least another $350bn of capital to deal with yet-to-be-realised losses. Yet, as Lehman's bankruptcy demonstrates, capital is harder to come by and considerably more expensive. Government- sponsored re-capitalisation appears unavoidable and ought to be anticipated by policymakers.
* The creation of government- backed asset management companies would allow problem banks and non-performing assets to be sold or run down in an orderly fashion. The establishment of a "clearing house" to net liabilities, including in credit default swaps, may also be necessary.
* Although depositors have remained - for the most part - calm amid the turmoil, broader assurances on bank deposits may be required, backed by adequate funding for the FDIC and other national deposit insurance entities.
The strong theme underlying the Minsky Moment - the tipping point between market euphoria and decline - is that a systemic problem in the financial system requires a systemic solution. Central banks can do and have done a great deal to keep the financial system liquid and funded. But the nature of the ongoing deleveraging, in which declining asset values, debt reduction and asset sales reinforce one another, calls for additional intervention by government.
The matter is pressing in its own right, but also because most of the advanced economies are either already in or on the verge of recession. This is no longer just a financial matter.
The author is chief economist at UBS
Copyright The Financial Times Limited 2015. You may share using our article tools.
Please don't cut articles from FT.com and redistribute by email or post to the web.