OPINION:British scheme is being seen as a promising template for the recovery of confidence in lending, writes Patrick Honohan
FRENCH FINANCE Minister Christine Lagarde is reported to have told G7 ministers the other day that her experience as a champion synchronised swimmer had taught her how to co-ordinate with others - and how to hold her breath.
The financial world held its collective breath over the weekend hoping for more decisive co-ordinated official action as the crisis accelerated - and it got a measure of co-ordination in Paris last night when euro zone leaders pledged to guarantee loans between banks until December 31st, 2009, so as to address the liquidity crisis.
Major banks have been further squeezing their borrowing customers. This has had knock-on effects. For example, hedge funds which had financed their investments with borrowing were forced to sell parts of their equity holdings, thereby contributing to the record share price falls during the week. And there is talk of perfectly routine export credit transactions being suspended or delayed, hampering the flow of international trade on which the world economy depends so heavily.
The underlying cause remains the same as it has been for 14 months: bankers' uncertainty about each others' creditworthiness, and each one's fear that a failing counterparty will imperil their own ability to pay up on time.
But the intensity of the fear has increased steadily since the Lehman bankruptcy four weeks ago. Every fall in share prices and every increase in the interest rate at which banks are willing to lend to each other both indicate the increased fear, and contribute to it.
This pattern of panic contributing to forced sales and idle factories has been seen before, of course, but the complex interdependence of today's international financial system and the lack of a hegemonic global financial power means that past solutions would not now be sufficient. Previous episodes have been arrested by decisive collective action to suspend normal rules, or the normal functioning of the markets in some way.
The question now is: what will work quickly to break the downward spiral and allow financing of the real economy to resume before too much damage is done? Clearly the immediate future is one in which some features of financial capitalism will be de facto suspended. This is already implicit in the scheme originally announced by the British government on Wednesday last and now being deepened and its implementation accelerated.
This provides extensive guarantees (though still not as unnecessarily broad as those granted in Ireland) to major banks who have agreed to boost their capital. The UK government is now prepared to make equity investments in these banks if they cannot find investors elsewhere.
Most economists writing this week believe that, by both boosting the largest banks' capital and ensuring their access to liquidity, the British scheme provides a promising template. Indeed, if something like it is not introduced soon for the systemically important banks headquartered in other countries, unilateral UK action will be unable to prevent the global recession. And every day that passes heightens the need for broader action.
In fact, other countries have been converging on such an approach. Following the expression of principles in the G7 communique on Friday night, the world anticipates concrete action. The US treasury is reported to be adapting its famous $700 billion plan in this direction (instead of just purchasing bad assets). The German government has indicated that it too is moving in this direction, and the French government is similarly disposed, although it has claimed its banks don't need help at present.
The global importance of Swiss banks means that Switzerland, too, should be doing something, but its banks may be too big for their government to cope with. Dealing with the Swiss case would be a natural goal for any worthwhile internationally co-ordinated action. It was not done for Iceland, but its banks were insignificant on a global scale and in much worse shape than the Swiss.
The immediate focus is now on the globally important banks working again. In effect, to preserve the functioning of the market-based economic system in which we live, governments are having to override some of the normal functioning of the broken financial markets dominated by these large banks.
The exceptional guarantees they are being given have to be combined with tougher capital requirements and additional restraints on their actions. It is these banks whose problems threaten the global economy, and whose self-serving behaviour no longer adequately serves the public interest at this stage of the crisis. If immediate action to restore their mutual confidence in lending to one another is successful, attention can then shift to the rest of the top 100 banks and then to smaller institutions.
The meetings in Washington this weekend involve not just the G7 but extend to the 185 member countries of the IMF. Given the growing financial resources and economic importance of China, as well as some other large developing countries, this could be the moment when these countries break into the inner councils of international financial diplomacy. Certainly some Western bankers have been looking to the East for a bailout.
Ireland will remain peripheral to such grand discussions, which is just as well. Yet they set the context within which we can deal with our local challenges. Under the circumstances, the rising Government borrowing requirement expected in tomorrow's budget will not attract as much adverse international attention as it otherwise would. Furthermore, the demonstration effect from abroad should stiffen the regulator's determination to ensure that Irish banks are adequately capitalised.
The global crisis must not be allowed to detract from the reality that a considerable part of our problems in Ireland is homegrown, and that fiscal imbalance, and probable capital weakness (of at least some of the Irish banks) do need firm and measured action.
• Patrick Honohan, professor of international financial economics, Trinity College Dublin