SO MUCH for Plan A. It vanished in a fiery liquidation last week that saw share prices in Britain fall by a quarter and was washed away in Wall Street in a total meltdown. Without further action soon – and that is within the next few days – we are looking at the breakdown of the world financial system with devastating consequences.
This past week has been the most catastrophic experienced in global markets for a century. While the crisis is global in nature, the UK economy is very exposed because of the massive debt-fuelled boom of the last few years. In addition, the UK bankin
g system's funding gap has risen sharply – that is, credit extended to the UK private and public sectors has risen much faster than deposits by those sectors.
This heightens our vulnerability to the global storms. Citigroup economist Michael Saunders says: "Prospects for the UK economy are grim. The UK is in the early stages of a severe recession. Unemployment and business failures are likely to soar. Further public bailouts of the banks may well be needed over time."
Now here is some hopeful news. There are still big guns left to fire, if there is the international will and determination to use them. It is time to be blunt. If last week's epochal sell-off in markets does not convince European leaders of the need for cooperation then they, their grand "European Project" and the single currency will be next up for the demolition ball.
There is a second item of hopeful news. Not only is there confidence that the Gordon Brown bank rescue plan can still work, but there are also increasing signals that US Treasury Secretary Hank Paulson will unveil an American-flavoured variant of it this week.
My third reason for hope is that central banks, having managed an impressively coordinated half percentage point reduction in interest rates last week, now have the logistical wherewithal to fire another coordinated cut. And this week would be none too soon.
Stock markets in America and round the world have seen waves of panic selling. There is reason for this selling, up to a point. The world is now entering a very sharp economic slowdown. The tumble in the oil price – Brent crude fell $6.01 to $76.65 on Friday, the lowest for more than a year – signals as much. Share prices across the manufacturing and services sectors need to reflect the new reality of recession ahead; one that will be severe in the UK. But price adjustment is one thing. Maniacal panic is another. And governments and central banks need to cauterise a collapse that shows every sign of feeding into the real economy through mortal blows to consumer and business confidence.
At least no one can doubt the gravity of the situation we are now in. However, I was astonished last week to hear on BBC Radio 4's Today programme, and again on BBC's Newsnight, Chancellor Alistair Darling being aggressively grilled about the bank rescue plan on the grounds that Government money could be better spent elsewhere. It is breathtaking that this far into the crisis some have still not grasped that the banking system is the nerve centre of the UK economy, and if it collapses then businesses collapse and no one gets paid, not even in the public sector. Yet the issue was treated as if it was yet another political spat.
There may be much to criticise in the presentation of the bank rescue scheme and the agonising delay between the floating of the idea in outline last weekend and the final announcement. But it is an intelligent and flexible plan, one that addresses the key problems of liquidity and recapitalisation, and which does not crush the position of the ordinary shareholders.
However, the plan was overwhelmed; first by the developing financial crisis in Iceland, and second by the rapid deterioration in confidence in the US, where deep recession fears have now taken hold.
In particular, trust among banks has sunk so low that the interbank market remains virtually paralysed. And measures by Eurozone governments to end the crisis have so far been uncoordinated and insufficient.
So what is Plan B? There are three cannons still to fire, and talk of a "super bazooka".
First, further cuts in interest rates are urgently required. While these do little in themselves to lower the interbank rate, they help to improve the banks' profits and would enable them to pass on further rate cuts to mortgage borrowers and businesses. This would help staunch the flight of confidence in the real economy.
Second, there needs to be a far more decisive and coordinated international response. It would be a big step forward if the meeting of the Group of Seven finance ministers this weekend moved to guarantee lending between banks, which could potentially bring down the relentlessly high London Inter Bank Offered Rate (Libor). Unless money markets ease up, more banks will fail. And stock market investors aren't going to get any relief until bank-to-bank lending comes down. Not only does it represent how unwilling banks are to part with their cash, but the rate is directly tied to many consumer loans, including adjustable-rate mortgages. If those rates rise, that will mean more mortgage defaults and foreclosures.
Third, US Treasury Secretary Hank Paulson referred to his $700bn Troubled Assets Relief Program (TARP) to buy the toxic paper of the US banks as a "bazooka". Now there is talk of a "super bazooka". It is increasingly likely that the US Treasury will copy the UK plan and recapitalise the major banks with cash injections through preference shares. At a White House press briefing on Thursday, a spokesperson indicated that the US Treasury was "actively considering" capital injections into troubled US banks.
It will use its new authority under the TARP legislation to make direct capital injections into the US banks and to provide other support, as needed to get wholesale markets working again. Ironically, this was what Mr Paulson had rather vigorously opposed two weeks before.
A rise in bank capital would reduce the risk of interbank lending. And a rise in overall capital in the banking system is probably necessary to halt the vicious cycle of fire sales, asset price declines, capital depletion, loss of lending capacity and economic decline.
However, one problem is that the US banking system is much more dispersed than the UK model, where the Government was able to corral together the top seven banks plus the biggest building society and hammer out an agreement. America has dozens of medium-sized banks that would want to qualify.
Finally, the administration should grasp the nettle of mark to market accounting – one of the key reasons why bank assets are being driven to fire-sale prices. Previously, banks were able to value asset paper in their accounts on a reasoned estimate of their value on maturity. Under the mark to market accounting rule, such assets must be valued at the price they would fetch on the open market were there an immediate sale. It seemed a prudent enough change at the time. But it is nonsensical in highly febrile conditions such as now, when normal market operations are just not working. Mark to market accounting is seriously compounding the problem.
Here's another helpful hint: reintroduce the ban on short selling. This ban expired on Wednesday night, contributing to the massive sell-off on Wall Street on Thursday. What on earth was the US Securities and Exchange Commission playing at?
This is a critical week – another one – requiring the boldest action.
