By Peter Boone and Simon Johnson
Sunday, October 12, 2008
The global financial outlook grows more dire by the day: The United States has been forced to shore up Wall Street, and European governments are bailing out numerous commercial banks. Even more alarmingly, the government of Iceland is presiding over a massive default by all the country's major banks. This troubling development points not only to an even more painful recession than anticipated, but also to the urgent need for international coordination to avoid something worse: all-out financial warfare.
The ramifications of Iceland's misery are probably more serious than people realize. The country's bank assets are more than 10 times greater than its gross domestic product, so the government clearly cannot afford a bailout. This is going to be a large default, affecting many parties. In the United Kingdom alone, 300,000 account holders face sudden loss of access to their funds, and the process for claiming deposit insurance is not entirely clear.
But there's a broader concern. With European governments turning down his appeals for assistance, Iceland's prime minister, Geir Haarde, warned last week that it was now "every country for itself." This smacks of the financial autarchy that characterized defaulters in the financial crisis in Asia in the late 1990s. Similarly, when Argentina defaulted on its debt in 2001-'02, politicians there faced enormous pressure to change the rule of law to benefit domestic property holders over foreigners, and they changed the bankruptcy law to give local debtors the upper hand. In Indonesia and Russia after the crises of 1998, local enterprises and banks took the opportunity of the confusion to grab property, then found ways to ensure that courts sided with them.
This is a natural outcome of chaotic times. Iceland's promise to guarantee domestic depositors while reneging on guarantees to foreigners may be just a first step. British Prime Minister Gordon Brown's decision last week to sue Iceland over this issue may escalate the crisis. The use of counterterrorist legislation to take over Icelandic bank assets and operations in the United Kingdom also has a potentially dramatic symbolic effect.
Most of the time, financial war of this kind is painful and costly. It will lead to decades of lower international capital flows and could have other far-reaching effects on politics and global peace. Unless the leading industrial countries take concerted action, there's a very real danger that we will all suffer more.
In addition, we're now likely to see substantially more defaults and credit panics in smaller countries and emerging markets. After Iceland's fall, every creditor to other nations with large deficits and substantial external debt must be looking for ways to reduce its exposure. The obvious risks include much of Eastern Europe, Turkey and parts of Latin America. Russia's difficulties show that seemingly solvent countries can be high-risk: While the Russian central bank has gold and foreign exchange reserves of $556 billion, the private sector has recently built up an estimated $450 billion of debt. Creditors don't want to roll over the debt, so the government is using its reserves to do it. It has already ordered $200 billion channeled through state banks to companies repaying debt. If oil prices fall, a seemingly highly solvent country could quickly look nearly insolvent. Some other rising stars, such as Brazil and even India, may have similar problems.
Added to this are worrying signs that the credibility of U.S. authorities is on the decline. Despite Washington's moves to stabilize the financial system, credit and equity markets continue to drop. This pattern is reminiscent of the 1997-98 Asian crisis, when successive International Monetary Fund programs provided briefer and briefer respites from market routs in emerging economies.
There is now a risk that continued corporate and bank defaults within nations, matched by large shifts in capital flows across nations, will lead to a chaotic series of national and local defaults. If governments don't respond with sensible, coordinated policies, there's a risk of financial war. Here are six steps toward avoiding a situation of "each nation for itself":
1. The world's leading financial powers -- at a minimum, the United States, the United Kingdom, France and Germany -- should jointly announce national plans to require recapitalization of banks (i.e., restructuring their debt and equity mixture) so that they have sufficient capital to weather a major global recession. How this is done can be determined internally by each nation, but this should be a common goal, so that citizens and companies can again trust their banks.
2. The countries should announce a temporary blanket guarantee on all existing bank deposits and debts. This will, in effect, promise creditors that they can safely expect the institutions to function until the recapitalization takes place, and it will help prevent the large flows of funds that could occur as some banks or countries conduct recapitalizations earlier than others. This guarantee should only be temporary (say, for six months).
3. The monetary authorities of these countries need to lower interest rates dramatically. Europe, Canada and the United States recently announced a coordinated 0.5 percent reduction in rates. This is a good start, but only a start. More will be needed, and it won't stop the credit crunch within or across countries. The events of the last nine months have set us on course for a global recession in which commodity prices will continue to fall and demand will remain weak. Inflation will be low, and deflation (falling prices) is a risk. More interest-rate cuts will be needed.
4. The monetary authorities also need to remain committed to pumping liquidity into the financial system as long as credit markets and interbank lending remain weak. This should be promised for at least one year.
5. All industrialized countries and most leading emerging markets should commit to a sizable fiscal expansion (at least 1 percent of GDP), structured to work within the local political environment, to offset the coming large decline in global demand.
6. Many families worldwide are going to have negative equity (i.e., mortgages larger than the value of their homes) due to declining home prices. There are going to be large-scale recriminations against lenders and politicians. The most affected nations, including the United States, the United Kingdom, Ireland and Spain, urgently need to develop programs to provide relief for homeowners, both to offset real hardship and to prevent a vicious downward cycle in home prices.
It's important to prepare properly: Partial and piecemeal actions will no longer work. Actions by one country alone, and the current pattern of small steps, are no longer credible enough to change the tide: Markets need to be jolted out of their panic. It's worth bringing a sufficient mass of economic power to bear in a comprehensive program to unfreeze the markets. If the major powers of Europe and the United States were to implement such a program, we can be sure that other countries would follow suit, dramatically relieving fears of bank failure in these countries.
We also need to let prices move to a level supported by the market, which unfortunately means that wealth is likely to decline even further. The events of the last six months will almost surely cause a recession, and large downward revisions in earnings estimates are a near certainty. The crisis has undoubtedly changed investors' perception of the risks of investing in equities and real estate. As we saw after the Asian crises, this can mean that stocks, bonds and other assets become very cheap, and it takes a long time for values to recover. Fiscal expansion and help to homeowners will reduce the pain from these losses, but it's important to be clear that the success of the program should not be measured by rising asset prices.
Finally, it's important for everyone to recognize that we are well past the days where even dramatic steps could have stopped the panic and prevented a major recession. A successful program will not prevent recession, and we will still see many personal, corporate and perhaps even national bankruptcies. Once the genie of panic and uncertainty is unleashed, it takes years to put it back in the bottle. What we need to do is to prevent a chaotic collapse arising from incomplete policies, lack of credibility and international financial warfare.
Peter Boone is chairman of Effective Intervention, a U.K.-based charity. Simon Johnson is a professor at MIT's Sloan School of Management. With James Kwak, they run the economic crisis Web site BaselineScenario.com.