There is no doubt that the world is in the midst of a financial shock. Vigilance, objectivity and collaboration are needed to deal with the challenges.
Exceptional times, exceptional solutions
These are exceptional times. Exceptional for what has happened to financial markets - it can only be described as a meltdown. And exceptional for what has not happened, at least not yet, to the broader economy - the onset of a severe recession. Perhaps it was the absence of the latter that lulled too many into viewing the bursting of the housing bubble merely as a correction, the defaults in US subprime mortgages just as misfortune, and the failure of important financial institutions as collateral damage.
Six months ago, when the IMF predicted more than US$1 trillion (Dh3.67tn) in financial sector losses and predicted a sharp slowdown in the global economy, we were criticised for being too pessimistic. But with much of the losses yet to be realised, and with the financial crisis now acute, it has become clear that the stopgap solutions of the past year will not work, and that nothing short of a systemic solution - comprehensive in tackling the immediate fallout and comprehensive in addressing the root causes - will permit the broader economy, in the US and globally, to function with any semblance of normality.
For the near term, such an approach must include three elements: liquidity provision; purchase of distressed assets; and capital injections into financial institutions. First, the central bank must prevent runs on banks and financial institutions. It can do so by reassuring depositors that their bank deposits are safe and by providing liquidity to financial institutions against good collateral. This was the first line of defence in the past year, and central banks have probably done by now most of what they could do.
Second, the Treasury must remove the reason why runs come in the first place, namely the presence of distressed assets in the balance sheets of financial institutions. International experience shows that an effective way to do this is to set up a government agency to buy these assets and hold them until they can be sold again or until they mature. A key issue will be the price at which these assets are acquired: high enough to induce financial institutions to sell, but also low enough that the state has a chance of making a return and keeping its own long-term finances in order. There are also other, potentially less costly, alternatives to outright purchases. For example, early this year the IMF proposed a solution based on longer-term swaps of mortgage securities for government bonds - which cleans up bank balance sheets in the near term but leaves the long-term risk with banks, not the state.
Third, the financial system must be recapitalised - at this point, probably with the help of the state. At the core of this crisis is the fact that the financial system as a whole has too little capital. Even if bad assets are removed, many institutions will still be short of capital, without which they cannot safely extend fresh credit to the economy. It is possible for the state to provide capital to banks in ways that do not imply nationalisation. For example, many IMF members in a similar predicament in the past have matched private capital injections with preferential shares and forms of capital that left ownership control in private hands (albeit with due safeguards for the taxpayer).
I welcome the bold steps being taken in the US. As details become known, we will see to what extent the US plans to cover these three bases. Other advanced economies should also be preparing contingency plans along these lines. To the extent that comprehensive approaches are put in place, I am confident that financial systems that had grown too large relative to the economy will stabilise at a more appropriate level. But what about the long-term challenges?
An obvious one is the fiscal cost. The upfront cost in terms of public debt is high but the ultimate cost to the taxpayer need not be. International experience shows that, done right, the government can expect to recover most of its initial investment. But if fiscal costs could turn out to be large, substantial fiscal adjustment may be required to underpin long-term economic prosperity and stability.
But there is an even deeper structural issue to be resolved. To put it bluntly, this crisis is the result of regulatory failure to guard against excessive risk-taking in the financial system, especially in the US. We have to make sure it does not happen again. Work has started to rebuild the architecture, and the world's leading industrialised countries have already put forward recommendations for prudential regulation, accounting rules and transparency. The role of credit rating agencies, on which global finance has relied, will also need to be rethought, with greater public scrutiny. In a globalised world, these efforts will have to be broad based. It is my hope that when the world's finance ministers and central bank governors convene in Washington DC next month, it will be possible to have global dialogue, so that all countries can draw lessons and tailor these recommendations to their own specific circumstances.
Finally, how might the financial shock play out in the rest of the world? European economies are already slowing markedly and, with further hits to bank capital, this process will continue into next year. Emerging market countries have been resilient, although there are those who argue that the wheels will fly off these fast growing economies as capital flows dry up and commodity prices tank. But we should be careful not to treat emerging markets as a block. Some will be helped by falling commodity prices and cooling demand, while others have built strong buffers of higher reserves, lower debt and credible monetary policy frameworks that they can draw on. That said, there will be problems to resolve in many countries, advanced and less so.
Vigilance, objectivity, and collaboration - on a global scale - will be needed to deal with the challenges ahead. Dominique Strauss-Kahn is the managing director of the International Monetary Fund