CREDIT IS the lifeblood of markets and when it stops flowing to businesses and consumers, a financial crisis for banks and stock market investors quickly becomes a major problem for the real economy. No economy can function properly once credit stops circulating freely and when banks fail to perform their role as lender and borrower, businesses are starved of cash, investment is delayed or abandoned, jobs are put at risk and consumers find it harder to secure mortgages and loans.
The continuing impasse in the world’s money markets, where credit remains frozen with little business being done, has greatly increased the risk of global recession despite the efforts of policy-makers to avert it. Credit markets operate on the basis of trust and when it is lacking and fear predominates – as we are seeing – those markets can freeze up with devastating financial and economic consequences.
On Wednesday the world’s major central banks announced a co-ordinated cut in interest rates in an effort to lower borrowing costs, raise investor confidence, restore some of that missing trust and help unblock the credit markets. The Federal Reserve, the European Central Bank, and others, had hoped to reverse the downward spiral of fear that has paralysed global money markets for weeks, spooking investors and panicking stock markets world wide from Russia to the United States. Banks have been reluctant to lend to each other, fearing default on loans they might make. Stock market investors, anticipating economic recession as a consequence of the continuing credit crisis, have rushed to dump shares in a disorderly stampede from equities to the relative safe haven of cash. In a world of deflating asset prices, gold – not surprisingly given the financial turmoil – has been the only appreciating asset class.
The rate-cutting move by the world’s major central banks has failed to impress the markets. Banks regarded it as a necessary step but one that has proved insufficient to overcome their fears. Banks remain risk averse. While willing to borrow from central banks, they remain reluctant to lend to other financial institutions because they fear default by the borrower. So banks now prefer to hoard than to lend.
Former El Salvador finance minister Manuel Hinds put it well this week when he drew an analogy between a poker game and the frozen credit markets, where those involved share a common concern, the solvency of participants. In a poker game, if a minority of players are broke but remain unidentified, then prudent and solvent card players will be reluctant to join the game since their winnings will not be paid by any insolvent gamblers who lose at the card table. Likewise in the credit markets, banks are unwilling to lend to each other when few are certain their loans will be repaid given the questionable solvency of other financial institutions.
Overcoming that difficulty is the key to restoring confidence and trust in the credit markets. Quite how that best can be achieved has so far defied the policy-makers and time is not on their side.