The crisis, which started sometime in August 2007, has deepened rather than abetted. In September this year when Lehman Brothers went bankrupt, a fault line was crossed, beyond which there is great uncertainty. Banks are seriously dysfunctional as they are not sure whom they can lend to since every other bank’s leverage position is precarious. There is still a lot of bad debt around in the G-7 banking systems. Hank Paulson has now done a turnaround on the issue of toxic assets. How a Treasury Secretary could go to the Congress, utter dire warnings of what would happen if he was not given $700 billion, and then weeks later turn around and say he would not use the money for the purpose for which it was granted is beyond me. How did this man run Goldman Sachs?
Of course, the problem is that no one is quite sure of the variety of financial products still out there whose nominal values are in free fall, and whose settlement is still not being done. In the field of default swaps alone, the sum is in trillions, and although a large part of the gross debt can be cancelled out against parallel claims and the net exposure is small, no one is willing to get into bilateral settlement of mutual claims. The variety and amounts of toxic assets will now be left to banks to sort out since Paulson has decided to pass money on to banks rather than try and get into a price revelation exercise himself.
If you are lost by all this, don’t worry. Most people even in policy-making positions are swimming in half ignorance and trying out anything that might work. One view is that this is not a breakdown in the system but a breakdown of the system. Banks have stopped behaving like banks. Their capital positions are too weak relative to their liabilities, and in many cases they themselves are not yet fully sure of how big their liabilities are. Since everyone was behaving as if the easy money position would last forever, and they had convinced themselves that their new sophisticated financial instruments had practically eliminated risk, they did not realise that they were behaving imprudently. As Keynes once said, it is easier to fail all together than to stand out from the crowd and chart your own success or failure.
How much worse could it get? My worst-case scenario is a much larger intervention by G-7 governments in their banking systems with huge infusions of money for recapitalisation. This is merely a way of government taking over private liabilities on its own books. It is still not quite nationalisation because the shareholders are still being left to cope with the volatility of equity prices of banks, but in some way the systemic capacity to advance credit is being preserved. It is a way of treating the financial system itself as a public good.
How sound are the governments themselves? In the UK, the debt GDP ratio is under 40% by one measure but there are a lot of off-balance sheet commitments thanks to Private Finance Initiative, and one estimate puts the true ratio at around 80%. But the total liabilities of the banking system are 420% of GDP and if the state were to take them over, the viability of the state itself would be in question.
Can sovereign states go bankrupt? During the petrodollar glut, Walter Wriston of Citibank said they could not. Through the 1980s, the Third World Debt problem loomed over the global economy and eventually foreign claimants of Third World Debt were forced to settle at a fraction of the nominal value. But what happens if the debt is all domestic? Then we have to think through the monetary aspects of such debt because the only way the state can pay back its debt is to print money, which it can do in unlimited amounts. Thus the state can never go bankrupt as such but the economy may suffer a sustained regime of inflation. You don’t even have to be a monetarist to believe that when the debt GDP ratio is so high.
Maybe it will not come to that. There are real strengths in the G-7 economies that have to do with the knowledge, the skills and the entrepreneurial ability of their citizens. After all, we have all the technological innovations of the last 25 years still available. Microsoft may go bust, but WORD is indestructible since it is in someone’s head. Maybe the final lesson of the crisis will be that the real strength of any economy is the quality of its human beings.
The author is a prominent economist and Labour peer