The Europeanisation of the Credit Crisis

By Edward Harrison On Oct 5, 2008

I have been a bit on edge of late because of the credit crisis that is making headlines. Recently, a lot of people have been duped into believing that the economic crisis we are experiencing is not critical and have their eyes focused elsewhere. However, this event is potentially the most critical event in world history since World War II.

It is not just a U.S. or UK problem — this problem has truly global dimensions. Europe has recently moved center stage in the credit crisis. Consider this turn of events the Europeanisation of the credit crisis.

Belgium, France, the UK, and the Netherlands all have nationalised large domestic banks. Ireland, Greece and now Germany have guaranteed bank deposits. And a Lehman-style bankruptcy in the form of Hypo Real Estate (HRE) is threatening Germany as we speak.

I had hoped we could get out of this with a minimum of fuss, but this thing is metastasizing in unimaginable ways. The major economic powers need to understand that now is not the time for political posturing and sticking your head in the sand. This crisis is reaching dangerous territory where debt deflation and untold economic pain could result. We are truly at a crossroads where economic depression is a very real possibility.

The crux of the matter is that a general crisis of confidence has hit the banking system because too much debt and too many complicated financial products have caused some banks to become effectively insolvent. But, which ones? No one knows and that has caused lending to grind to a halt as everyone is afraid of lending to a bankrupt borrower.

The Paulson Plan is not going to solve this problem by a long shot. And, until a few days ago, the Europeans were acting like this was an Anglo-American problem. It is not. Recently, I wrote a piece in the Guardian where I outlined what needs to be done in the U.S. and Europe. It comes down to four things:

Guarantee bank deposits. To halt the decline, The U.S. and European governments should follow Ireland, Greece and Germany and make an explicit guarantee of deposits to end potential distrust among depositors. I believe political will for this already exists and Europe will certainly do it, will the US?
Guarantee interbank lending. Governments need to bite the bullet and temporarily guarantee interbank loans taken at Libor (the London interbank offered rate). This would unfreeze the inter-bank market, which is creating liquidity problems in the financial sector.
Liquidate insolvent financial institutions. But, as guarantees increase moral hazard, governments must require national regulators to quickly determine which banks are insolvent. The government can then decide on whether to liquidate these insolvent banks or sell their assets to other financial institutions.
Re-capitalize the banking system. The private sector should be used to re-capitalize the remaining solvent banks. Many investors are ready to contribute capital under the right circumstances. However, if necessary, the government should contribute through preferred shares or warrants.

Regulators might also look to separate “good” assets from “bad” assets in the solvent banks to further bolster interbank confidence. Instead of buying assets up at inflated prices, as treasury secretary Hank Paulson has suggested the U.S. government do, they should stick bad assets into a separate “bad bank” controlled by the regulators at market prices.

I am not the only one thinking along these lines. Just today Willem Buiter, a former Bank of England MPC member made comments along the same lines. These fixes are extremely urgent because confidence in the banking systems worldwide are declining. Governments need to act now.

Related article
Getting the interbank market going again: the central bank as counterparty of last resort – Mavercon Blog, FT