Sunday, March 30, 2008

Not yet time for a bail-out of banks (FT)

Published: March 28 2008 19:49 | Last updated: March 28 2008 19:49
The “credit crunch” is nearly eight months old, yet shows little sign of easing. It has already forced the US Federal Reserve to slash its benchmark interest rate by 3 percentage points. It has driven central banks to make huge injections of liquidity into markets. Yet this activity has failed to give confidence to markets. So has the time come for a fiscal bail-out? The short answer is: no.

“The heart of the problem is not in the real economy; it is in the financial sector itself,” argued Mervyn King, governor of the Bank of England this week. “It stems from an ‘overhang’ on banks’ balance sheets of assets in which markets have closed ... That has created uncertainty about the strength of banks’ financial positions.”

Inevitably, banks are now unwilling to extend credit. So spreads between official interest rates and the rates at which banks will lend to one another are unusually high. Worse, these spreads have again been rising in recent months.

The many signs of frozen lending are, in turn, creating a lobby for the “something must be done” school. The most plausible “something” is an injection of public money into the mortgage market or, heaven forbid, the financial industry itself.

Such an infusion is to be contemplated only in the direst circumstances. This is not now close to being the case in any affected country. Moreover, the extent of the losses to be tackled will only be known when asset prices stop falling. For this very reason, that point should be reached as soon as possible. Governments should, therefore, avoid trying to support the housing market, but allow it to adjust, instead. Only then will the value of outstanding mortgage-backed securities, and of the institutions that hold them, be known.

So what should be done now? Central banks must use monetary policy to avoid the risk of economic collapse. They should also try to make illiquid securities less so, while leaving credit risk with their holders. Where adequate room for manoeuvre exists, fiscal policy should support monetary policy.

Governments can also help by facilitating renegotiation of mortgages. The principal aim is to avoid unnecessary and costly foreclosures. Finally, regulators should be willing to let institutions operate with somewhat inadequate capital for a while, provided they have clear plans to rectify the situation.

Does this mean that a fiscal bail-out should be ruled out under all circumstances? No. If the financial system were to be so damaged that it proved impossible to sustain aggregate demand, the public sector would have to step in. But it should do so only over the dead bodies of shareholders and management. Those who caused the crisis must not be rescued by taxpayers from the results of their copious follies.

In the meantime, we must understand one point: the hangover from the party will endure a long while.

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