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The Response to the Crisis

After much dithering, high drama and every effort to avoid the inevitable for fear that it would straightjacket capitalism, governments in the developed industrial countries bought new equity in private banks to recapitalise them, effectively nationalizing a large part of the private banking system.

These moves came at the end of a long series of interventionist efforts that pointed in two directions. First was that governments believed that the problem facing the financial sector in the wake of the subprime crisis was not one of generalised insolvency, but one of inadequate liquidity resulting from fear and uncertainty. The second was that to the extent that there were individual firms faced with insolvency, the problem could be resolved on a case by case basis, through closure (Lehman), merger (Wachovia) or state take over (American International Group). It was only when efforts based on these perceptions failed to stop the slide that measures to deal with generalised insolvency, such as buying out all impaired assets or recapitalizing banks with public investment were resorted to. But even these are focused on the banking system. In a world where non-bank financial institutions play an extremely important role and the banks themselves are integrated in various ways with these institutions, it is unclear whether these steps would be enough.

The perception that the problem was one of liquidity because financial markets were freezing up given the difficulty of assessing counterparty risk yielded a host of responses, especially in the US, that filled the media with acronyms: MLEC (Master Liquidity Enhancement Conduit), TAF (Term Auction Facility), TSLF (Term Securities Lending Facility) and PDCF (Primary Dealer Credit Facility) (Shiller 2008). By the end of it the Federal Reserve in the US had offered to accept as collateral the bundles of worthless assets that were lying with financial firms, and extend its credit facilities to entities outside the regulated banking system. Interest rates too had been substantially cut to make credit cheaper. When even this was not yielding the expected results and halting a slide in stock markets, recognition that other measures were needed dawned. Some effort at dealing with insolvency was called for.

But even this was initially half-hearted and pursued on a case-by-case basis. Further, across cases the attitude was different. JP Morgan Chase was paid off to take over Bear Stearns cheap. Lehman was allowed to go. Fannie Mae and Freddie Mac were nationalized. AIG was rescued with a huge infusion of public funds, triggering allegations of conflict of interest on the grounds that this was an effort at protecting Goldman Sachs that was substantially exposed to the insurer. Treasury Secretary Paulson came from Goldman and still held a significant stake in the firm. But as the number of cases multiplied and the lack of a clear strategy became obvious, the danger of a financial collapse intensified.

This was when the first signs of recognition that there was a problem of potential generalised insolvency emerged. The first response was TARP (Troubled Assets Relief Program). Declaring that the system was faced with financial collapse of a kind that could drive the economy to recession, the Treasury Secretary backed by the Chairman of the Federal Reserve, badgered Congress into authorising a $700 billion bailout package, which was primarily geared to buying out the near-worthless or “impaired” mortgage-related assets from financial institutions, as also any other assets from any other party so as to “unclog” their balance sheets and get credit moving.

This plan too did not clearly recognise that generalised insolvency was a potential problem. This was clear from the fact that the bailout plan sought to use market-based methods to buy up troubled assets. Since the prevailing market price of those assets was close to zero, this would imply that the institutions selling those assets would have to take large write-downs onto their balance sheets and reflect these losses. This would undermine their viability and result in failure unless they were recapitalised with an infusion of new funds.

It was the UK, having experimented with liquidity infusion and limited nationalisation, which first went beyond the Bush administration. Gordon Brown announced that his government would resort to an “equity injection” to buy ordinary and preference shares worth £37 billion in three of the biggest banks in the country: Royal Bank of Scotland, Lloyds TSB and HBOS.

Existing shareholders have the option of buying back the ordinary shares from the government. But if they do not, as seems likely, then the government would have a stake of 60 per cent in RBS and 43.5 per cent in the combined entity that would emerge after the ongoing merger of Lloyds TSB and HBOS. This clearly amounts to State takeover, which brings with it new obligations. The three banks will not be able to pay dividends on ordinary shares until they have repaid in full the £9bn in preference shares they are issuing to the government. The Treasury appointed new directors to the boards of RBS and the combined Lloyds-HBOS to oversee the government’s interests. And restrictions were imposed on executive salaries and bonuses that had ballooned during the years of the speculative boom.

The decision to nationalize was forced on the UK government because the problem facing the banking system was not just one of inadequate liquidity resulting from fears generated by the subprime crisis. Rather credit markets had frozen because the entities that needed liquidity most were those faced with a solvency problem created by the huge volume of bad assets they carried on their balance sheets. To lend to or buy into these entities with small doses of money was to risk losses since that money would not have covered the losses and rendered these banks viable. So money was hard to come by. This is disastrous for a bank because rumours of its vulnerability trigger a run that devastate its already damaged finances.

What was needed was a large injection of equity to recapitalize these banks after taking account of losses. Wherever the sum involved was small, a private sector buyer could play the role, otherwise the State had to step in. Thus, in the case of some banks recapitalization through nationalization was unavoidable because, as UK chancellor Alistair Darling put it, “this is the only way, when markets are not open to certain banks, they can get the capitalisation they need”. Others such as Barclays hoped to attract private investors so as to avoid being absorbed by the government.

What needs to be noted, however, is that nationalization is not the end of the matter. In addition, the UK government has chosen to guarantee all bank deposits, independent of their size, to prevent a run. It has also decided to guarantee inter-bank borrowing to keep credit flowing as when needed.

Once the UK decided to take this radical and comprehensive route, others were quick to read the writing on the wall. What followed was a deluge. Germany with an estimated bill of €470 billion, France with €340 billion, and other governments with as yet unspecified amounts pitched in, with plans to recapitalize banks with equity injections, besides guaranteeing deposits and inter-bank lending. The banking system was being saved through State take-over, not just with State support.

Finally, the US, which was seeking to avoid State acquisition fell in line, but in a form the shows the influence that Wall Street exerts over the Treasury.  It too has decided to use much of the $700 billion of bailout money to acquire a stake in a large number of banks. Half of that money is to go to the nine largest banks, such as Bank of America, Citigroup, Wachovia and Morgan Stanley. The minimum investment will be the equivalent of one per cent of risk-weighted assets or $25 billion-whichever is lower. With capital adequacy at a required 8 per cent, this is indeed a major recapitalisation. Further the government, through the Federal Deposit Insurance Corporation, is guaranteeing all deposits in non-interest bearing accounts and senior debt issued by banks insured by the FDIC.

However, Wall Street’s influence has ensured that this intervention is biased in favour of Big Finance. The support comes cheap: banks will pay a dividend of just 5 per cent for the first five years, only after which the rate jumps to 9 per cent. During that time, they have the option of mobilising private capital and buying out the government. Interestingly, the government is not taking voting rights and would be able to appoint directors only if the bank misses dividend payments for six quarters. While there are restrictions on payment of dividends to ordinary shareholders before clearing the government’s claims and limits on executive compensation, the government only reserves the right to convert 15 per cent of its investments into common stock. In sum, the American initiative overseen by Henry Paulson, an old Wall Street hand from Goldman Sachs, has virtually cajoled the banks to accept a government presence, unlike what seems true in the UK and Europe.

Whether it is occurs in part-punitive fashion or as a sop, the back-door takeover of major private banks is a desperate attempt to stall the financial meltdown in the advanced economies resulting from the decision to allow private financial players unfettered freedom to pursue profits at the expense of all else. That threat has forced governments to drop their neo-conservative bias against State ownership and markets that hollered at government intervention in the past have now applauded such action.

Fall-out for the Real Economy

However, the threat of recession has not receded. Even if the banks are safe, though there is no definite guarantee as yet, there are many other institutions varying from hedge and mutual funds to pension funds that have suffered huge losses, both from the subprime fiasco and the stock market crash, eroding the wealth of many. Moreover, housing prices are still falling sharply. The effects of that wealth erosion on investment and consumption demand are only now unravelling, indicating that there is much to be told in this story as yet.

The crisis had a number of consequences in the developed countries. It made households whose homes were now worth much less more cautious in their spending and borrowing behaviour, resulting in a collapse of consumption spending. It made banks and financial institutions hit by default more cautious in their lending, resulting in a credit crunch that bankrupted businesses. It resulted in a collapse in the value of the assets held by banks and financial institutions, pushing them into insolvency. All this resulted in a huge pull out of capital from the emerging markets: Net private flows of capital to developing countries are projected to decline to $530 billion in 2009, from $1 trillion in 2007 (World Bank 2008). The effects this had on credit and demand combined with a sharp fall in exports, to transmit the recession to developing countries. All of these effects soon translated into a collapse of demand and a crisis in the real economy with falling output and rising unemployment. This is only worsening the financial crisis even further.

As 2008 entered its final month, predictions of where the world economy is heading turned dire. The World Bank projected world output to grow by a mere 0.9 per cent in 2009 (as compared with 2.5 per cent in 2008 and a high of 4 per cent in 2006) and world trade to contract by a significant 2.1 per cent (compared to positive rates of growth of 6.2 per cent in 2008 and a high of 9.8 per cent in 2006).. Moreover, the World Bank could identify no possible driver for a recovery in the coming months.

Other projections are even more pessimistic. Chapter 1 of the UN’s World Economic Situation and Prospects 2009, released in advance at the Doha Financing for Development conference, estimates that the rate of growth of developed country output which fell from 4.0 per cent in 2006 to 3.8 per cent in 2007 and 2.5 per cent in 2008 is projected to fall to 1.0 per cent in 2009 as per its baseline scenario and to -0.4 per cent in its pessimistic scenario.

Finally, the recently released preliminary edition of the OECD’s Economic Outlook for end-2008 shows that GDP in most OECD countries declined in the third quarter and is likely to fall also in the fourth. In the event, GDP growth in the OECD area which fell from 3.1 per cent in 2006 to 2.6 per cent in 2007 and 1.4 per cent in 2008 is projected to fall to -0.4 per cent in 2009, and the unemployment rate which rose from 5.6 per cent to 5.9 per cent between 2007 and 2008 is expected to climb to 6.9 per cent in 2009 and 7.2 per cent in 2010.

If these predictions turn out to be true the prognosis is that what was a recession in 2008 could turn into a depression in 2009. Looking back, 2008 was a year when the recession unfolded. The recession in the US, reports indicate, is not recent but about a year old and ongoing. Short term indicators are disconcerting, but do not convey the real picture. Preliminary estimates of GDP growth in the United States during the third quarter of 2008 point to decline of half a percentage point. But GDP growth during the previous two quarters was positive at 2.8 and 0.9 per cent respectively. The only other quarter since early 2002 when growth was negative was the fourth quarter of 2007. Thus, going by the popular definition of a recession-two consecutive quarters of decline in real gross domestic product-the US is still to slip into recessionary contraction.

But the independent agency which is the more widely accepted arbiter of the cyclical position of the US economy is the Business Cycle Dating Committee of the National Bureau of Economic Research (2008). This committee, which adopts a more comprehensive set of measures to decide whether or not the economy has entered a recessionary phase, has announced that the recession in the US economy had begun as early as December 2007. That already makes the recession 11 months long, which has been the average length of recessions during the post-war period. There is much pessimism on how long this recession would last as well. According to the OECD, for most countries “a recovery to at least the trend growth rate is not expected before the second half of 2010 implying that the downturn is likely to be the most severe since the early 1980s, leading to a sharp rise in unemployment.”

In fact, differentials in the distribution of the impact of the recession and a recovery in 2010 are the only positive elements in analyst predictions. Most predictions, as for example that of the World Bank, hold that the decline in growth rates in emerging markets would be much less than in the US.  Thus, growth in developing countries as a whole is expected to fall from 6.3 percent in 2008 to 4.5 per in 2009, only to recover to 6.1 per cent in 2010. This is mainly due to China and India without which the figures are a more disappointing, but still relatively creditable at 5, 2.9 and 4.7 per cent respectively.

However, even here, the numbers are proving to be disconcerting. China’s growth has been slipping even if still relatively high. But nobody can ignore the fact that manufacturing, which is the engine of growth in that country is hugely dependent on exports to developed country markets, especially the US. Second, according to Bank of Korea estimates, South Korea’s economy will contract in the last quarter of 2008 and grow at its slowest pace in 11 years in 2009. According to its estimates, the economy, the fourth largest in Asia, would shrink by 1.6 per cent in the fourth quarter of 2008, and grow only at 2 per cent in 2009, and 3.7 per cent for full 2008. And the month-on-month annual rate of growth of India’s Index of Industrial Production fell by 0.4 per cent in October, for the first time in 15 years.

These developments make predictions of a significant growth recovery in 2010 appear optimistic. A question that troubles analysts is how long this recession will last. The recovery assessments are based on the assumptions that the crisis in financial markets would be resolved soon and that there would be no negative feedback loops both between the real sector and the financial sector (which would exacerbate the financial crisis) and within the real sector (which would intensify the crisis in the real economy), before the positive effects of intervention by governments materialize in full. Such assumptions are indeed tenuous, increasing the lack of certainty about a recovery. Thus, job losses in the US are increasing the number of housing foreclosures. Around 7 per cent of mortgage loans were reported to be in arrears in the third quarter of 2008, and another 3 per cent are at some stage of the foreclosure process. According to the Mortgage Bankers’ Association, about 2.2 million homes will have entered foreclosure proceedings by the end of 2008. This would intensify the financial crisis as well as dampen consumer spending, and could worsen the downward spiral.

Yet, unemployment figures suggest that at the moment the recession is only intensifying. On December 5, 2008, the Bureau of Labour Statistics in the US reported that employers had reduced the number of jobs in their facilities by 533,000, taking the unemployment rate in the US to 6.7 per cent. This reduction-which is the highest monthly fall in 34 years-comes after job losses of 320,000 in October and 403,000 in September.

Total job losses through 2008 are 1.9 million. This means that the 2.5 million jobs that President-elect Obama is promising to deliver through his fiscal stimulus package would just about recover the jobs lost during the recessionary period preceding his swearing in, and leave untouched the backlog of unemployed and those entering the labour force during this period. Thus even the coming of new government in the US does not give cause for optimism.

A crisis of this nature requires holes to be plugged at many places simultaneously. While there is wide agreement that what is need is a globally coordinated and huge fiscal stimulus, the actual effort on the ground remains fragmented and meagre. Because of this results are disappointing, threatening to make this crisis the most protracted in a long time. Year 2008 is likely to be remembered as a year in which a crisis of immense proportions unfolded.

If the stimulus now being attempted in Europe and elsewhere and the one that Barack Obama promises to implement do not yield the expected results, demands for protection are bound to increase. Governments that spend to boost their own economies which find that the benefits leak out into the international system boosting demand and production elsewhere could turn protectionist too. That would spell a retreat from current levels of global integration.

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