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.

By Invitation: Buy lots of mattresses

Wall Street woes

By V Anantha Nageswaran

In the last few months, financial markets had got used to the idea of the authorities conjuring up some solutions to problems in the US financial industry over the weekend and announcing it on Monday morning (Asian time) in time for the Asian stocks to open higher. This routine worked initially but when problems did not go away, the impact became rather muted.

Unfortunately for Lehman Brothers such a weekend solution did not arrive. Late on Sunday evening in the US it announced that it was going to declare bankruptcy. Wanting to avoid that fate, Merrill Lynch sold itself to Bank of America. Some called it tectonic shifts on Wall Street. Alan Greenspan, former chairman of the Federal Reserve said that America was facing once-in-a-century financial crisis. He should know better because he played no small role in creating it. Continue reading “By Invitation: Buy lots of mattresses”

The knave of bad times

They destroyed the paddle. Schitt creek* is coming up

Growth in industrial production fell to 3%, the lowest in six years, indicating that bad times might be ahead. There’s worse. As Niranjan Rajadhyaksha demonstrates, the UPA government has frittered away the opportunity to put the economy on the footing to handle the coming problems. In the “misery index” he constructs, among emerging market economies, only Pakistan and Egypt fare worse than India.

But there is little doubt that the economic fundamentals are deteriorating. The hole in the government’s finances is getting bigger. It could now be close to 1991 levels, if measured correctly. The current account deficit, too, is growing and could conceivably touch 1991 levels by the end of this year. The foreign exchange market has already picked up these worrying signs. The rupee has been slipping against most major currencies over the past few weeks. Somewhere in some tax haven, a few hedge funds must be seeing these trends and sharpening their claws.

It is unfortunate and inexcusable that India is now at a point when it seems far more vulnerable than most other emerging market economies. The government should have used the splendid five-year economic boom and soaring tax collections to slash its deficit and prepare the economy for an economic downturn. It did not.

History will not judge the United Progressive Alliance government too kindly on this score. It is distressing that some of the same people who helped pull India out of trouble in 1991 have done so little to prepare for the next round of economic turmoil. One expected more from a team led by Manmohan Singh.[Mint]

Mr Rajadhyaksha is being charitable to Dr Singh and the UPA government. Not only did this crew fail to prepare for the coming storm, but actually damaged the boat. It’s a sin of commission. [Also see Swaminathan Aiyar’s piece on fiscal deficit]

* Thanks to Chidanand Rajghatta for revealing the decorous use of that euphonious euphemism