Financial crisis: How to stop the panic

The world's governments are shocked and dismayed by their inability to
stop the increasingly grave financial crisis. Nothing they have
attempted has gotten lending flowing normally. Profitable companies
are cut off from borrowing. Confidence is shot.

Through Oct. 7 the U.S. stock market had its worst five-day
performance since 1932 on fears of a severe economic downturn. Says
Stephen Jen, currency economist at Morgan Stanley in London: "The
choices for the real economy are between a recession and a
depression."

Can anything be done to halt this panic? As a matter of fact, yes. It
won't be quick or easy. But the prerequisite for a new approach is
unlearning doctrines that were developed in the aftermath of the Great
Depression, the last time financial conditions were worse than this.
The world has changed in the intervening seven decades, and what
worked to quell the financial crisis then may not work now - as anyone
trying to borrow money can see.

So far, crisis managers in the US and abroad have relied mostly on
using "helicopter money" - that is, dropping dollars across the
financial landscape in hopes of reviving lending and spending.
Generations of mainstream economists around the world learned this
approach at the feet of the late Nobel laureate economist Milton
Friedman, who coined the helicopter metaphor.

Federal Reserve Chairman Ben Bernanke, while parting from Friedman in
some particulars, shares his general approach - and in fact earned the
moniker "Helicopter Ben" after citing Friedman's coinage in a 2002
speech.

Following this logic, the Federal Reserve is aggressively lending
money to all comers. The synchronized international rate cuts on Oct.
8 - which lowered the US federal funds rate to just 1.5% - is another
example of helicopter money.

Central banks figure that by flooding the banking system with
reserves, they can get banks to relend the money to the rest of the
economy. But while lowering interest rates and providing liquidity is
essential, it's no longer enough, says Paul J J Welfens, president of
the European Institute for International Economic Relations in
Wuppertal, Germany. Says Welfens: "It's very dangerous if you don't
have a strategy. The situation is worsening because no one is doing a
(basic) program to restore confidence."

An alternate approach that's gaining favor in many quarters is to
place money strategically where it can do the most good, even if that
means picking winners and losers and allowing some channels of credit
to dry up for the time being. One tactic: direct government
investments in selected banks on a large scale.

The theory behind this approach is that the banks are so wounded that
simply lending them more money won't solve anything. To restore their
positive net worth so they can lend freely, banks need fresh equity,
and government is the only party that's capable of providing it in
these extreme conditions. Sweden used this strategy to end a banking
crisis in the early 1990s.
And on Oct. 8, Britain took a giant step in the same direction,
announcing an offer to buy up to $88 billion worth of preferred shares
in Britain's biggest banks. The government also said it would
guarantee up to $437 billion of the banks' debt. "This is beginning a
process of (undoing) a big problem where banks won't lend to each
other for long periods," Chancellor Alistair Darling told Sky News.

On Oct. 8, US Treasury Secretary Henry Paulson broadly hinted that
Washington is likely to use a targeted approach with at least some of
the $700 billion authorized by Congress to deal with toxic mortgage-
backed securities and other assets - including buying equity shares in
some financial institutions.

A targeted approach doesn't waste money on weak banks that deserve to
disappear. "You are going to see significant consolidation in banking
across Europe. As the tide goes out, the weak models and weak
managements are revealed," says Robert E. Diamond Jr., president of
Barclays, the British banking company.

More policymakers and economists are coming around to approaches such
as Britain's because of the manifest failure of loans, guarantees, and
asset purchases to get the job done. In fact, an unhealthy dynamic has
developed. The Fed and other central banks have steadily expanded the
portions of the economy to which they are lending freely - in effect,
declaring them to be protected within the walls of the fortress. But
it's having unintended consequences.

Central bankers' desperate extension of credit to new kinds of
borrowers simply worsens the condition of solvent institutions left
outside the walls, because investors and lenders pull money out of
them. That explains the wild swings in stock prices and credit
spreads.

For example, the branches of British-owned banks in Ireland lost money
to locally owned rivals after Dublin offered blanket protection on all
deposits of Irish-owned banks there. And in the US, corporations that
borrow in the commercial paper market were cut off from funding
because investors moved to safer Treasuries - forcing the Fed to say
on Oct. 7 that it would step in to buy the commercial paper itself.
The logical endpoint of this game is for governments to protect all
financial assets. That's an awfully Big Government outcome for an
approach that started out with a small-government thrust.

Moral hazard:

US policymakers have sometimes departed from the helicopter-money
approach, as in the rescues of Fannie Mae, Freddie Mac, and American
International Group, which gave the government big equity holdings.
They may need to jettison another bit of orthodoxy, which is that it's
dangerous to make explicit promises of taxpayer support for fear it
will encourage risky behaviors.

Economists have long been taught to avoid creating "moral hazard" -
giving people an incentive to take big risks. Letting Lehman Brothers
fail was intended to send a warning to risk-takers. But by trying so
hard to avoid moral hazard, governments aren't giving markets the
confidence they need, says Richard Portes, an economist at the London
Business School, adding: "In circumstances like this, the last thing
you want is ambiguity."

The longer the banks are incapacitated, the worse the damage to the
real economy. "Banking institutions are really the rock foundation of
all of the economic activity that occurs," says Edward Liebert, who is
treasurer of Philadelphia-based chemical maker Rohm & Haas as well as
chairman of the National Association of Corporate Treasurers.
Policymakers are getting the message.

"Generally speaking, central banks and governments are just beginning
to understand the severity of the crisis and how it impacts on their
economies," says Donald Moore, chairman of Morgan Stanley in Europe.
"My view is we are going to take another three to six months to sort
this." It may take that long for the generals to learn how to fight
this war, not the last one.

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Courtesy: Rohit,_._,___