Only full disclosure of toxic debts will get the West moving again
It has been a year of financial explosions.
By Liam Halligan
Last Updated: 9:24PM GMT 27 Dec 2008
The commercial pillars holding up the Western world - banking prudence and sound credit - have been smashed to smithereens
The "advanced" nations are now flirting with economic collapse. The emerging economies have also suffered "collateral damage" – the West's "sub-prime" debt bombs now threatening the stability of global commerce.
The developed world is on course to contract by 1.1pc during 2009. That will hurt. The emerging markets are also set to slow – their growth falling to 3.1pc – as China and India feel the impact of lower Western demand.
But 2010 could be even worse – unless policymakers can piece the global economy back together. And the prevailing policy response –soft bail-outs, ultra-low interest rates and unfettered government spending – not only won't work, but will compound this crisis.
So how should Western governments respond? How can we escape this credit crunch, and prevent it being repeated?
As the Bank of England Governor Mervyn King said last month, "getting the banks lending normally again . . . is more important than anything else". After piling into risky assets for years, the Western banks now refuse to lend to millions of credit-worthy firms and households. That's jammed the wheels of finance, making fears of recession self-fulfilling.
The money markets are locked because the banks don't trust each other. Even they don't know how much toxic debt is out there – and which bank could be the next to fall. That's why the spread between the London Inter-bank Offered Rate and overnight interest rate swaps of the same maturity remains so wide – and wider in the UK, now, than either the States or the eurozone.
The crucial inter-bank market will remain frozen until the banks are forced, under threat of prosecution, to reveal the true extent of their sub-prime liabilities. Such "full disclosure" won't be easy – involving the exploration of millions of complex derivative contracts, often across borders – but it simply must be done.
America's first serious reaction to "sub-prime" was the Troubled Assets Relief Programme – buying up hundreds of billions of dollars of dodgy loans the banks didn't want any more. When that didn't work, the US asked banks to forfeit some share capital in return for government cash, as in the UK.
But that's failing too – as shown by sky-high Libor rates. So, as a matter of urgency, the West must copy the hard-headed Swedes – who, in the early 1990s, insisted nationalised banks write down the full extent of their non-performing loans before more public money is spent on recapitalisation. Only then – once the sub-prime losses are fully-exposed – can securities markets clear and the inter-bank market reboot.
The UK/US approach of piling public sector debts on top of private sector debts prevents this vital purging process. Until it happens the global economy will continue to slide. But the big Western economies remain in self-denial, repeating the mistakes made by the Japanese. We're creating our very own "zombie banks" – technically alive, but commercially dead due to the weight of their toxic debts. A Western "lost decade" now looms.
So we need Swedish-style full disclosure. Nothing else will break the deadlock and get us out of this fix. Western politicians – and commentators – need to stand up to the powerful money men and administer the necessary medicine.
Instead, all our leaders do is slash interest rates, print money and rack up public debt. History will judge them harshly.
After full disclosure, how do we prevent such a crisis happening again? Firstly, the "white collar" crimes which drove this sub-prime debacle – at mortgage lenders, investment banks and ratings agencies – need to be severely punished. People who did bad things must go to jail. I'm against regulatory overkill, but recognise a strong framework of rules is needed. We need to acknowledge that too much leverage is even more dangerous than too little. Western central banks need to regain powers, weakened in the 1980s and 1990s, to impose "reserve asset requirements", so reining in bank lending.
Above all, we need to re-introduce the Glass-Steagall Act of 1933. This legislation – the centre-piece of America's response to the 1929 Wall Street crash – was copied across the Western world.
Glass-Steagall prevented commercial banks – which take in deposits and service ordinary firms and households – from engaging in the high-risk speculative activities undertaken by investment banks.
In the early 1990s – after huge lobbying by Wall Street, and lots of ridiculous talk about "freedom" – the legislation was repealed. No other single action has done more to cause this crisis.
The money men have, so far, managed to close down any talk about restoring Glass-Steagall. But that debate must now take place. That's why Glass-Steagall will be the subject of my first column of 2009.