STAMFORD
Lingering hope that by some ad hoc measures Europe could isolate itseconomies from the financial cyclone battering the US came crashing last week.Amidst indications that stability of top Western banks have sunk below many inthe developing world, European leaders frantically worked to devise solutions toprevent economic collapse. Denial about the totally interconnected economic lifeof today’s globalized world is no longer possible, but new battle will beginabout the shape of capitalism to emerge from the present ruin.
Alarm bells started ringing with the stunning collapse of the Icelandic bankingsystem in early October, leaving the island nation of 320,000 with prospects foran economic contraction of around 10 percent and likely dependence on theInternational Monetary Fund for its survival until recovery starts. As centralbankers and finance ministers scramble for solutions, Europeans are bewildered,worried and mistrustful. It’s obvious that failure to restore confidence willresult in ongoing descent into a 1930s-like crisis, pulling along a train ofsevere macroeconomic and sociopolitical consequences.
The stark reality facing many European banks and investment and pension funds isthat they bought many of the same toxic financial products that sank USfinancial institutions. In other cases, European banks overextended in lendingto local real estate markets and to Central and Eastern European markets.Consequently, slowing economic growth; tighter credit, as banks were quick toreduce lending; and extended evaporation of interbank lending, where banks lendto other banks, functioned much like a brake to a rapidly moving car. Interbanklending, in particular, became an acute problem, forcing the Bank of England,the European Central Bank and others to pump euros and pounds into the marketsto guarantee some degree of liquidity.
Markets continued to be unstable, but unlike the rapid US acceptance of a $700billion program to buy troubled assets from banks and implementation of theFederal Reserve program to purchase commercial paper, European governmentsremained adverse to a single policy response.
French President Nicolas Sarkozy briefly suggested the idea of a €300 billion,or US $460 billion, bank rescue fund. This was, however, rejected by GermanChancellor Angela Merkel, leaving the European Union with a commitment toprotect the financial system, but little else. As one commentator noted, the EUhad "a common market with no common rescue plan."
Lack of a broad, over-arching EU policy failed to calm investors or stop thecrisis. In rapid succession, but in haphazard fashion, the largest Beneluxfinancial conglomerate Fortis was rescued by joint Dutch, Luxembourg and Belgianintervention; the UK government intervened in the troubled building societyBradford & Bingley; the German government helped cobble a rescue loan forHypo Real Estate. When these measures failed to stem the rising panic and theGerman government was forced to pull together yet another rescue deal for HypoReal Estate, Fortis was sold to BNP de Paribas in Luxembourg and Belgium andnationalized in the Netherlands, and Dexia, the world’s largest lender tolocal governments. The dangerous risk of the financial crisis to the rest of theeconomy was evidenced by Dexia’s troubles. A failure by Dexia would havethreatened €290 billion of commitments with local governments. The danger oflocal governments losing ability to finance development would be a problem inmuch of Europe, with a major impact on citizens’ daily life.
What’s evolved in the European Union is a rush by member states to createtheir own bank-rescue and depositor-protection plans. Along these lines, Irelandmoved first to guarantee deposits in all personal bank accounts as well asbacking debt of its banks. Other European countries followed out of fear oflosing their bank deposits to Ireland’s safer program. In addition, Spainannounced a €50 billion plan to buy assets from its banks, hoping to nudgeopen credit markets.
In the UK, growing concerns over losses at such large institutions as the RoyalBank of Scotland, Halifax Bank of Scotland, Barclays and others saw thegovernment resort to a partial nationalization of some of the country’slargest financial institutions. The Brown government implemented a program withas much as £50 billion, or $97.2 billion, to buy preferred shares in banks toboost capital. In addition, the government raised the level the Bank of Englandmakes available for banks to borrow to at least £200 billion. France and Italyalso created bank-protection programs, and Germany soon joined in with €400billion in loan guarantees, providing as much as €80 billion to recap banks,and setting aside €20 billion in its budget to cover potential losses fromloans.
Despite the plethora of European government programs, investor confidence mayremain elusive for two reasons – the large costs of financial bailouts andconcern over the possibility that one of Europe’s large transnational banksfails. The International Monetary Fund estimates that total losses andwrite-downs from the credit crisis will amount to $945 billion, and there arehigher estimates in excess of $1 trillion. Thus far, according to Bloombergcalculations, total losses are $633 billion, with $383 billion in the Americas,mainly the United States; $225 billion in Europe; and around $25 billion inAsia. Chances are that the European losses will grow, possibly approaching thesame level as the Americas.
The major priority is to restore confidence, and this comes from creating a moreuniform G7 plan. In a practical sense this means defining which banks are toobig to fail, creating cross-border safety nets for those that might be too bigto save, partially nationalizing the banks where necessary and pumping capitaldirectly into the interbank market to guarantee transactions between bankscurrently reluctant to lend to one another. This also means overcomingideological stickiness over state intervention, fear of bailing out others orneed to cast blame.
Over the weekend of October 11-12th, EU leaders made another effort to stabilizemarkets, with three measures, which could be fine-tuned: Member states willguarantee new bank debt until the end of 2009; governments will shore up banksby buying preferred shares; and they announced a commitment to recapitalize any"systemically" critical banks in distress. There’s also an indication thatmeasures would be further coordinated within the G7.
The current financial crisis is the most serious since the 1930s. Although manyEuropeans blame the US for the financial panic due to its almost blind faith inunfettered free markets, models and derivatives, globalization has left themvery interconnected to US markets. While the financial philosophy guiding the USand UK is very similar, continental Europe holds a view that this is a chance toreshape the financial sector for the "public good." This philosophyvery much ties into the main battle over the commanding heights of the globaleconomy that’s sure to begin as markets stabilize.
Now that the US model has had its comeuppance what type of capitalism shouldemerge? There is a smorgasbord – quasi-authoritarian capitalism (Russia),authoritarian capitalism (China) and within democratic capitalism, you haveAnglo-American, Continental and Japanese-Asian versions.
Whatever model emerges as the winner, there can be no divorce between the US andEurope in this regard. The stakes are exceedingly high and further steps arerequired to restore confidence.
Scott B. MacDonald is a senior partner and head of research at AladdinCapital Management, LLC, in Stamford, Connecticut, and currently writing a bookon Asia and globalization. Rights: © 2008 Yale Center for the Study ofGlobalization. YaleGlobalOnline
