Understanding the global financial crisis

Credit asphyxiation

Ajay Shah describes the reasons for the crisis, and the current panic…

Once a financial panic starts, only government intervention can solve it. Once trust is lost, only governments, with the power to print money and pay off debt through future taxes, can offer credible financial guarantees, and get the financial sector to work again.

An ideal big government effort at resolving these problems would involve three elements. It would involve stemming the bleeding of housing-related securities that are available at fire sale prices and are very illiquid. It would involve a government induced and policy supported mechanism for financial firms to raise fresh equity capital, going beyond the hundreds of billions of dollars that financial firms have raised by themselves. And, I think it would have to involve some mechanism through which the top 20 financial firms would get a detailed look at each others internals, so that they can start trusting each other and the money market can sputter to life.

The Paulson plan which has obtained support from lawmakers in the US is explicit about the first element: the US government will buy something like $700 billion of housing-related securities. This is a step in the right direction. But the other two problems remain : financial firms are low on equity capital and don’t trust each other. We continue to live without a money market. [Ajay Shah/FE]

…and what might solve it.

One of the most promising elements of a policy response has come from the UK on Tuesday. This involves three elements: liquidity injection to compensate for the collapse of the money market, guarantees for medium financing of banks, and equity injections into eight banks. Key design features of this package, and the magnitudes of resources involved, appear to have improvements compared with the American efforts. If this leads to a revival of the money market in London, this would mark a major step forward in resolving the crisis.
[Ajay Shah/FE]

Related Links: Niranjan Rajadhyaksha on how the crisis might affect the Indian economy, and what the Indian government should do about the global crisis.