HereÆs what one London banker says about the events: ôYesterday (Wednesday) was stupid: Goldman is okay, Morgan is okay, UBS is okay (maybe a little damaged), etcetera, etcetera. I hope that when the dust settles they jail a lot of hedge funds (too rude to print) for spreading false rumours.ö
In fact, there is no need to panic. The US still has a major trump card, namely its enormous financial resources. As Kenneth Rogoff, Harvard economics professor and former chief economist of the International Monetary Fund, pointed out in the Financial Times on Thursday, privately held US debt only amounts to 35% of AmericaÆs $15 trillion GDP. JapanÆs debt to GDP ratio amounts to 215%, according to the research firm and brokerage Japaninvest. The problem is that the US government has not been consistent in indicating whether it will use that strength to defuse the current crisis.
In Japan, the government did make that commitment. It took over the role of generating demand after the economy de-leveraged radically from 1990 onwards. The idea was simple: the government would keep the economy going by running up a huge national debt until the private sector was fixed. ThatÆs pretty much how it happened. Companies now have far stronger balance sheets with record profits and the countryÆs finances are starting to improve.
The US must intervene equally energetically. Its ideological fixation on not bailing out anybody, but then reversing itself and bailing them out anyway at a much higher cost, needs to be sorted out. There is a case to be made that Merrill Lynch was unjustly forced into a frantic sale to Bank of America by the disastrous collapse of Lehman (orchestrated by the Fed/Treasury), despite having done a very commendable job in clearing its balance sheet and refocusing on safer, profitable areas. John Thain's genius may have been to recognise the impact of the Lehman failure on the value of his firm before anyone else did. He sold in the nick of time.
Then, last weekend, the government refused a $20 billion loan to AIG, before reversing itself again and handing it a lifeline of $85 billion, but in such a way that the government has no vested interest in AIGÆs future, apart from ensuring the survival of the firm to repay the loan and the usurious interest rate it has charged (three-month Libor plus 8.5%). Not surprisingly, the grudging move failed to pacify the equity markets, although it did apparently stabilise the vital CDS market.
The governmentÆs problem is that it must decide between two roles. The Fed/Treasury combination should not view itself as Judge Dredd (his slogan: ôjudge, jury and executionerö). It has no constitutional role to punish anybody. It is supposed to take instructions from the US president, although the White HouseÆs lame duck politicians havenÆt been giving much guidance on the issue.
The Fed/Treasury combination should be more like Superman, saving the world from Lex Luthor, the cartoon world's leading corporate criminal. Retribution and reform can follow under a new administration and with a popular mandate signaled by the result of the November election. Until then, the objective should be to stabilise the financial system. There will be a price to pay, of course: either a higher national debt and higher interest rates and/or a weaker dollar. That price is worth paying to avoid a chaotic financial system meltdown which could destroy the economy for decades.
In the meantime, itÆs clear that encouraging lending through cheap rates and supplying liquidity is not enough. The most recent (Thursday) Fed-coordinated $200 billion initiative provides liquidity to banks all over the world. But itÆs debt. The problem is that the system is already awash with debt. Adding more debt just adds to the length of the deleveraging process. The only thing that changes is the nature of the creditor. The new creditor should rationally have even tougher safeguards to protect himself û so the pressure on the debtor actually increases, even if he gets short-term relief. If the conditions of the government loans are easier than the original loans, one could argue it becomes a covert quasi-equity injection, but without the benefits of ownership and the chance of sharing in future gains. And without transparency to the tax payer regarding the true cost of the operation.
So there is a case to be made that what the system really needs is more equity. That can only be achieved by government intervention û for example, if it bought up mortgage assets on a massive scale. Adding equity is the only way to deleverage in an orderly fashion. An orderly deleveraging from existing levels without extra equity will only come when markets cease to panic û but what measure would stem panic? Most likely the promise of extra equity. ItÆs time to let Superman work his magic.