Back to Iraq | Being a recounting of my journalistic ventures in Iraq

I don’t know much about inter­na­tional finance, I’ll admit. So I’ll let Strat­for do the talk­ing for me, below:

The finance min­is­ters of the G-7 coun­tries are meet­ing in Wash­ing­ton. The first announce­ments on the meet­ings will come this week­end. It is not too extreme to say that the out­come of these meet­ings could rede­fine how the finan­cial mar­kets work, cer­tainly for months and per­haps for a gen­er­a­tion. The Amer­i­cans are argu­ing that the regime of inter­ven­tion and bailouts be allowed to con­tinue. Oth­ers, like the British, are argu­ing for what in effect would be the nation­al­iza­tion of finan­cial mar­kets on a global scale. It is not clear what will be decided, but it is clear that this meet­ing matters.

The meet­ings will extend through the week­end to include mem­bers of the G-20 coun­tries, which together account for about 90 per­cent of the global econ­omy. This meet­ing was called because pre­vi­ous steps have not freed up lend­ing between finan­cial insti­tu­tions, and the finan­cial prob­lem has increas­ingly become an eco­nomic one, affect­ing pro­duc­tion and con­sump­tion in the global econ­omy. The polit­i­cal lead­er­ship of these coun­tries is under extreme pres­sure from the pub­lic to do some­thing to solve — or at least alle­vi­ate — the problem.

Under­ly­ing this polit­i­cal pres­sure is a sense that the finan­cial class, peo­ple who run global finan­cial insti­tu­tions, have failed to behave respon­si­bly and effec­tively, and have there­fore lost their legit­i­macy. The expec­ta­tion, rea­son­able or not, is that the polit­i­cal sys­tem will now sup­plant these man­agers and impose at least a tem­po­rary solu­tion. The finance min­is­ters there­fore have a polit­i­cal man­date, almost global in scope, to act deci­sively. The ques­tion is what they will do?

That ques­tion then divides fur­ther into two parts. The first is whether they will try to craft a sin­gle, global, inte­grated solu­tion. The sec­ond is the degree to which they will take con­trol of the finan­cial sys­tem — and inter-financial insti­tu­tion lend­ing in par­tic­u­lar. (A pri­mary rea­son for the credit crunch is that banks are cur­rently afraid to lend — even to each other.) Thus far, attempts at solu­tions on the whole have been national rather than inter­na­tional. In addi­tion, they have been built around incen­tiviz­ing cer­tain action and increas­ing the avail­able money in the sys­tem.

So far, this hasn’t worked. The first prob­lem is that finan­cial insti­tu­tions have not increased inter­bank lend­ing sig­nif­i­cantly because they are con­cerned about the unknowns in the borrower’s bal­ance sheet, and about the bor­row­ers’ abil­ity to repay the loans. With even large insti­tu­tions fail­ing, the fear is that other insti­tu­tions will fail, but since the iden­tity of the ones that will fail is unknown, lend­ing on any terms — with or with­out gov­ern­ment money — is impru­dent. There is more lend­ing to non-financial cor­po­ra­tions than to finan­cial ones because fewer unknowns are involved. There­fore, in the United States, infu­sions and promises of infu­sion of funds have not solved the basic prob­lem: the uncer­tain sol­vency of the bor­rower.

The sec­ond prob­lem is the inter­na­tional char­ac­ter of the cri­sis. An exam­ple from the Ice­landic melt­down is rel­e­vant. The gov­ern­ment of Ice­land promised to repay Ice­landic depos­i­tors in the island country’s failed banks. They did not extend the guar­an­tee to non-Icelandic depos­i­tors. Partly they sim­ply didn’t have the cash, but partly the view has been that tak­ing care of one’s own takes pri­or­ity. Coun­tries do not want to bail out for­eign­ers, and dif­fer­ent gov­ern­ments do not want to assume the lia­bil­i­ties of other nations. The nature of polit­i­cal solu­tions is always that politi­cians respond to their own con­stituen­cies, not to peo­ple who can’t vote for them.

This week­end some basic deci­sions have to be made. The first is whether to give the bailouts time to work, to increase the pack­ages or to accept that they have failed and move to the next step. The next step is for gov­ern­ments and cen­tral banks to take over deci­sion mak­ing from finan­cial insti­tu­tions, and cause them to lend. This can be done in one of two ways. The first is to guar­an­tee the loans made between finan­cial insti­tu­tions so that sol­vency is not an issue and risk is elim­i­nated. The sec­ond is to directly take over the lend­ing process, with the state dic­tat­ing how much is lent to whom. In a real sense, the dis­tinc­tion between the two is not as sig­nif­i­cant as it appears. The mar­ket is abol­ished and wealth is dis­trib­uted through mech­a­nisms cre­ated by the state, with risk elim­i­nated from the sys­tem, or more pre­cisely, trans­ferred from the lender to the tax­ing author­ity of the state.

The more com­plex issue is how to man­age this on an inter­na­tional scale. For exam­ple, Amer­i­can banks lend to Euro­pean banks. If the United States comes up with a plan which guar­an­tees loans to U.S. banks but not Euro­pean banks, and Euro­peans lend to Europe and not the United States, the inte­gra­tion of the global econ­omy will very quickly shat­ter, lead­ing to sig­nif­i­cant lim­i­ta­tions on inter­na­tional trade, cur­rency con­vert­ibil­ity and so on. You will nation­al­ize economies that can’t stand being purely national.

At the same time, there is no global mech­a­nism for man­ag­ing rad­i­cal solu­tions. In tak­ing over lend­ing or guar­an­tees, the admin­is­tra­tive struc­ture is every­thing. Man­ag­ing the interbank-lending of the global econ­omy is some­thing for which there is no insti­tu­tion. And even with coor­di­na­tion, finance min­istries and cen­tral banks would find it dif­fi­cult to bear the bur­den — not to men­tion man­ag­ing the system’s Her­culean size and labyrinthine com­plex­ity. But if the G-7 in effect nation­al­ize global finan­cial sys­tems and do it with­out inter­na­tional under­stand­ings and coor­di­na­tion, the con­se­quences will be imme­di­ate and seri­ous.

The G-7 is look­ing hard for a solu­tion that will not require this level of intru­sion, both because they don’t want to abol­ish mar­kets even tem­porar­ily, and more impor­tant, because they have no idea how to man­age this on a global scale. They very much want to have the prob­lem solved with liq­uid­ity injec­tions and bailouts. Their incli­na­tion is to give the cur­rent regime some more time. The prob­lem is that the global equity mar­kets are destroy­ing value at extremely high rates and declines are approach­ing his­toric lev­els.

In other words, a cri­sis in the finan­cial sys­tem is becom­ing an eco­nomic prob­lem — and that means pub­lic pres­sure will surge, not decline. There­fore, it is plau­si­ble that they might choose to ask for what FDR did in 1933, a bank hol­i­day, which in this case would be the sus­pen­sion of trad­ing on equity mar­kets glob­ally for sev­eral days while admin­is­tra­tive solu­tions are reached. We have no infor­ma­tion what­so­ever that they are think­ing of this, but in start­ing to grap­ple with a prob­lem of this mag­ni­tude — and search­ing for solu­tions on this scale — it is totally under­stand­able that they might like to buy some time.

It is not clear what they will decide. Fun­da­men­tal issues to watch for are whether they move from manip­u­lat­ing mar­kets through gov­ern­ment intru­sions that leave the mar­kets fun­da­men­tally free, or do they aban­don free mar­kets at least tem­porar­ily.

Another such issue is whether they can find a way to do this glob­ally or whether it will be done nation­ally. If they do go inter­na­tional and sus­pend­ing mar­kets, the ques­tion is how they will unwind this sit­u­a­tion. It will be eas­ier to start this than to end it and state-controlled mar­kets are usu­ally not very attrac­tive in the long run. But then again, nei­ther is where we are now.

Reprinted with the per­mis­sion of Strat­for.