From The Observer (London):
The biggest bet in the world
By the time G7 finance ministers met on Friday afternoon, they were staring into the abyss. In a desperate effort to restore calm to the markets, they took decisive action and came up with a five-point plan, which includes spending billions of taxpayers’ money to rebuild the global banking system and reopen the flow of credit. This is how the drama unfolded …
* Heather Stewart and Larry Elliott in New York, Ruth Sutherland and Lisa Bachelor in London
* The Observer,
* Sunday October 12 2008
It was 19 minutes to noon on Wednesday when Gordon Brown took the call from Mervyn King. With the seconds ticking away to the Prime Minister’s first Question Time in the Commons since the summer break, the governor of the Bank of England had dramatic news: secret consultations between the world’s most powerful central bankers had resulted in the decision to make the biggest co-ordinated cut in interest rates there had ever been.
With the world’s financial system perilously close to complete meltdown, bankers were determined to show they meant business. The move was to be announced at midday in London and 7am New York time, and King was nervous that Brown might be embarrassed by a backbencher picking up the news via BlackBerry as he stood up to speak.
Brown had already been dealing with the financial crisis for more than six hours that morning, having held a 5am summit with Chancellor Alistair Darling at Number 11 to discuss details of a £50bn part-nationalisation of Britain’s bombed-out banks, due to be unveiled to the stock exchange that morning.
With just 10 minutes to go before world markets heard the news, King’s next call was to Darling. Both Prime Minister and Chancellor had been hoping for a rate cut for many weeks as the credit crisis began to take its toll on Britain’s cash-strapped borrowers, threatening to tip the economy into a severe recession.
Just before Brown stood up to explain his drastic bail-out plan to Parliament, US Treasury Secretary Hank Paulson was appearing before reporters in Washington in an attempt to reassure American voters that their savings were safe. Asked if he planned to emulate Brown’s bail-out package, Paulson was sniffy, defending his own $700bn ‘troubled asset recovery plan’. Yet within little more than 48 hours, he was signing up to a promise by the G7 finance ministers to pour public cash into struggling banks, buying shares to ease the severe shortage of capital in the world’s financial sector.
The reason for the volte-face was simple: Wall Street was locked into a vertiginous sell-off as terrified investors dumped stocks, commodities and the dollar, fearing that the mounting financial crisis would turn into a full-blown economic slump.
By the time the G7 finance ministers gathered in Washington on Friday afternoon, there was no doubt whatever that they were looking at disaster. The half-point rate cut, unthinkable just a few days before, was greeted with a shrug by investors who had lost their faith in governments’ powers to fix the world economy. Wall Street had suffered the worst week in its history, with the Dow Jones index losing an extraordinary 18 per cent of its value, and every major stock market had plunged, day after day. On Friday alone, the Dow hurtled an eye-watering 700 points downwards, then swung up into positive territory, before settling ‘only’ 128 points down.
General Motors, once the proud symbol of America’s car industry, was worth less by the end of the week than it was in 1929, and felt obliged to issue a statement saying it was not at risk of bankruptcy. By Saturday, it had announced talks about a merger with its rival Chrysler. Morgan Stanley was in desperate talks to save a proposed cash injection from the Japanese bank Mitsubishi, and on Wall Street the buzz was that Paulson’s damascene conversion to state intervention had been triggered by the impending demise of another household name of US banking.
Thousands of miles away in Iceland, once a sleepy but prosperous example of the cautious Nordic economic model, a decade of financial excess was ending in tears. Reykjavik has been brought to the edge of national bankruptcy by its overstretched financial firms, and deposits from thousands of British savers, along with money belonging to local authorities and charities, was tied up in Icelandic banks. An IMF team was dispatched to assess its need for an emergency loan. Reports in Washington suggested that other countries were also teetering on the brink of insolvency.
G7 ministers were keen to avoid the policy paralysis that had been so evident when Nicolas Sarkozy gathered the leaders of Europe’s big four economies in Paris a week earlier. Then, declarations of solidarity were swiftly belied by Germany’s unilateral decision to guarantee all bank deposits, an example of the beggar-my-neighbour behaviour that had helped to deepen the Great Depression. The world’s financial markets had delivered a clear message about the costs of indecision and disarray.
The strain of wrestling with the crisis was clearly visible on the faces of the finance ministers. France’s Christine Lagarde, Washington’s Hank Paulson and Alistair Darling all looked as if they had been burning the midnight oil – which they had. It didn’t help that on Saturday, they all had to be at the White House by 6.45am to get security clearance for their breakfast meeting with George Bush.
The President has repeated his mantra that if they work together, the West’s biggest economies would get through the crisis. For the first time since the turmoil entered a new and dangerous phase, Bush’s remarks did not send share prices tumbling – but only because the market was closed for the weekend.
Darling’s morning continued with a bilateral with Paulson, and talks with the new chairman of the Financial Services Authority, Lord Turner, over the plans for recapitalising some of Britain’s biggest banks, details of which will be announced tomorrow.
Around the table at the US Treasury, Darling argued forcefully that recapitalising banks with public cash was the only viable solution to the worldwide crisis. Japanese delegates, rarely the most vehement contributors to G7 debates, argued passionately that the lesson from their country’s own catastrophic banking crisis in the 1990s was that taxpayer-backed bail-outs of financial institutions should be carried out without delay. So keen was King to push home the importance of unblocking the credit markets, he summoned up the ghost of Elvis Presley, saying, ‘as the King would say – a little less conversation, a little more action’.
It was not Elvis but the desperate need to restore calm to the markets that really prodded the G7 into action, however. When civil servants presented a first draft of the communique, several pages long and packed with waffle, finance ministers said they wouldn’t sign it – because it wouldn’t work.
Italian finance minister Giulio Tremonti even went public, saying ‘the current draft is too weak’, and wouldn’t, at first, put his name to anything more than a page long. When the meeting ended, what emerged was a five-point plan, including a promise to buy up stakes in banks, on the British model.
Governments also pledged to prevent the failure of ‘systemically important’ banks, in a bid to avoid unleashing another financial domino effect like the one that followed the collapse of Lehman Brothers; take ‘all necessary steps to unfreeze credit and money markets'; ensure that consumers around the world can have confidence in the safety of their savings; and take action to kick-start stalled markets in the mortgage-backed assets and other securities that banks use to help fund their lending.
In other words, governments of the world’s richest countries
will unleash every weapon they have, including billions of pounds of taxpayers’ money, to rebuild the global banking system and reopen the flow of credit to consumers and households. Paulson called it ‘aggressive,’ but that was an understatement – it is financial ‘shock and awe’.
There are high hopes in Washington that this much concentrated firepower, perhaps combined with more drastic rate cuts from central banks, must eventually work – though European Central Bank governor Jean-Claude Trichet said it might still take time for the markets to respond positively. If this plan does succeed, finance ministers can stop worrying about the risk of total collapse of the world’s financial system – and start worrying about the long, grinding recession that most believe will follow this month of extraordinary drama.
When Paulson was drafted into Washington from Goldman Sachs in 2006, with his action man demeanour and impeccable Wall Street pedigree he seemed the ideal personification of America’s economic invincibility. Two years on, he, and the swashbuckling model of capitalism he represents look like a busted flush. Even even his friends on Wall Street have dramatically lost faith in his power to halt the financial storm.
For 50 years, America has been the global economy’s uncontested superpower, preaching open markets, financial liberalisation and free trade. Washington confidently believed it had the answer to the world’s economic problems, if only the unconverted would listen. But last week showed that the US has no magic recipe to assuage the violent fear that had seized Wall Street, let alone offer a blueprint for other governments to follow.
Every time delegates from developing countries thumbed through a newspaper, or glanced at a TV screen, they saw bleak red graphs of plunging stock markets or footage of an earnest-looking Bush using an emergency briefing in the White House rose garden to reassure shell-shocked American voters.
The US public are bailing out of mutual funds in their droves and discussing where the hard-earned cash they have saved for retirement or their kids’ college funds will be least at risk. Safe-makers are reporting rising sales as a growing number of Americans resort to the old-fashioned method of withdrawing their dollars and locking them up at home.
At every press conference within the tight ring of security that surrounds the IMF’s HQ, a forest of hands shot up, as journalists from Brazil, the Philippines, Russia, China and a host of other countries asked urgently what impact the crisis would have on their home countries.
For the past decade, World Bank and IMF meetings have been dominated by the problems of the world’s poorest countries. The crash of 2008 has followed the longest sustained boom in the global economy since the late 1960s and early 1970s, breeding the complacent belief that the only real issue was how to help poverty-stricken countries in Africa catch up. This year, the mood had changed: Africa barely merited a mention, as the West concentrated exclusively on preventing its home-grown crisis dragging the entire world into a slump.
The problem is twofold: in the short term, the vital need is to stop the financial virus from infecting every country in the world and having an even bigger impact on global growth. In the longer term it is how to rebuild a world financial system that has so comprehensively failed in the past 14 months.
In 12 months’ time, when the IMF gathers for its next annual meeting in Istanbul, the world may look very different. There is a palpable sense in Washington that even if the downturn is shorter and sharper than the IMF predicts, the domino effect that began in America’s housing market and has rippled throughout the world, is leaving in its wake a powerful momentum for reform.
Dominique Strauss-Kahn, the IMF’s managing director, stressed that there must be no return to ‘business as usual’ when the worst of the crisis is over. At the very least, there will be reforms to what the experts call the ‘global financial architecture’ – in other words, the rules will be tightened.
Credit ratings agencies, which assess how likely borrowers are to repay their debts, will find their activities reined in; regulators monitoring the behaviour of international banks across different jurisdictions will be forced to work more closely together; and the IMF is likely to be given stronger powers to issue warnings about the build-up of dangerous financial bubbles in the years ahead.
Central bankers who have contented themselves for the past decade with focusing on inflation, may well also be asked to take into account the risk that by cutting interest rates to keep economies out of recession they may be pumping up an unsustainable boom. Alan Greenspan, the former US Federal Reserve chairman, was once lionised as an economic ‘maestro’, but now appears to be a major architect of the crisis. The IMF said the world economy had been allowed to run above its ‘speed limit’ for too long.
The banks, which have been forced to beg for public cash to prevent their business model imploding, will find themselves under severe scrutiny from their new shareholder, the taxpayer. In return for rescuing them, governments will insist on limits on bonus payouts and curbs on dividends to shareholders.
There are broader changes afoot, too. Robert Zoellick, president of the World Bank and a veteran of the US Treasury, called for seven major emerging economies to join the traditional G7 club of rich countries to provide a better reflection of the new power balance in the world economy. Bringing Brazil, China, India, Mexico, Russia, Saudi Arabia and South Africa on board would create a powerful ‘steering group,’ representing 70 per cent of the world’s GDP and 56 per cent of its population. Zoellick’s pointed call for change underlines the mood for reform unleashed by the crisis.
Iceland may yet be forced to turn to the IMF for an emergency loan, but the fact that it was given direct financial support first by the Russian government underlines the power that countries which have built up huge financial surpluses – including Russia, but also China and many Middle Eastern economies – could wield in the years ahead.
How deep the changes go may depend on how badly the shortage of credit affects the global economy. The IMF believes that, after a grim year, with recessions in most major countries, the green shoots of recovery will be visible beneath the frost.
Olivier Blanchard, the IMF’s chief economist, insisted that with the right concerted action from governments, the risk that the financial crisis would give way to a full-blown depression on the scale of the 1930s was ‘almost nil’. Yet he was also quoted warning that share prices could have another 20 per cent to fall before calm is restored: hardly the sort of thing to reassure investors in the current environment.
The governments of the world’s largest economies think they’ve done enough to avert disaster. This week, they will be watching anxiously watching to see if the markets agree.
A year of rescues
14 September 2007
Bank of England steps in with emergency funding to support Northern Rock.
17 March 2008
Federal Reserve organises the rescue of Bear Stearns.
US government seizes control of mortgage lenders Fannie Mae and Freddie Mac.
US rescues insurer AIG.
US government takes control of Washington Mutual in the largest-ever American bank failure.
UK government nationalises Bradford & Bingley’s loan book.
Ireland guarantees the deposits of all savers.
Biggest ever US government bail-out plan – worth $700bn – clears House of Representatives after being rejected a week earlier.
Iceland asks Russia for €4bn loan to avoid financial
Chancellor Alistair Darling announces £450bn rescue plan for Britain’s ailing banks. Bank of England cuts interest rates by half a percentage point.
G7 meeting in Washington agrees global rescue plan
* guardian.co.uk © Guardian News and Media Limited 2008