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reflections

Oct 14, 2008 | 00:47 GMT

Geopolitical Diary: The Financial Crisis and the European and U.S. Solutions

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.
Both the Europeans and Americans have outlined how they plan to fight the global financial crisis. Now, onto the next problem. At its heart the financial crisis is this: Banks, afraid that other banks could go under at any time, are refusing to lend money to each other. Banks still willing to lend to their consumers — whether firms or individuals — are now utterly dependent upon their own cash reserves. That has drastically reduced the amount of credit in the system that can reach end users. Which means that a recession, a global recession, is hardwired into the system until the logjam breaks. The European solution, put together by the 15 states that use the euro, is to grant a state guarantee to interbank loans to remove the fear from the banks and reboot the system. The American solution has two parts. First, use federal money to empower the Treasury Department to purchase assets of questionable value (think subprime mortgage securities) from banks so their balance sheets are friendly and so other banks will be more willing to lend to them on the interbank. Second, join the interbank network itself via the Federal Reserve. Beginning Monday, the U.S. Federal Reserve System is now granting unlimited dollar-denominated loans to any bank affiliated with the Fed or a Fed proxy (which now includes every bank in Europe or Japan as well) that is interested so long as the bank can provide collateral. Both methods will introduce large-scale inefficiencies, but that is now deemed better than letting the problems run their course. Put simply, the Europeans are guaranteeing the individual transfers of existing banks, whereas the Americans are simply supplying the market itself by acting as if it were one of the banks (albeit a very, very large one). But having a plan and implementing a plan are two radically different things. In essence both plans require the government not simply to monitor, but actually to take over the interbank system — a financial exchange mechanism that has a substantial portion of the world's free capital floating within it. This will require a competent staff of thousands to function effectively, and a competent staff of thousands cannot be built up in a few days, and perhaps not even in a few weeks. So the global system is now in the odd position of having identified the road out, but not having any horses to pull the cart. The Europeans are going to have a harder time of this than the Americans, and not simply because there are thousands of finance professionals in the Wall Street area looking for jobs. By stepping in as the guarantor, the Europeans will be forced to evaluate every interbank transaction, matching the lender to the borrower at a government-approved rate. To simply issue the guarantee and walk away would allow any bank to lend to anyone risk free, and the size of the corruption that would stem from that would be far more mind-blowing than the market uncertainty that would be left behind. This must be managed actively and close up. The Americans, in contrast, are actually joining the interbank via the Fed. So rather than having to approve every interbank transaction, the Fed will only be negotiating with parties interested in dealing with the Fed itself. Similarly, the Treasury's bailout package will only deal with the specific purchases of questionable assets that the Treasury chooses to explore. Both will sport staggering caseloads, but both are far less unwieldy than the mammoth task the Europeans face of micromanaging every deal across the entire interbank market. Both Europe and the United States are now in a race against time. Simply having a plan in place is sure to inject some confidence and loosen up the interbank somewhat, but until the governments can actually force the market open, global credit will remain constrained. The severity of this recession will in many ways be determined by just how fast these programs can get staffed. And that's only the half of the problem that is for today. The other half is for months from now, when the time comes to get the government out of the business of banking. After all, outside of crisis times the market is a much better manager than the government. For the Americans the exit strategy should be somewhat easier: The Fed can simply put an upper limit on how many dollars it will supply the interbank on a daily basis and slowly ratchet the number back, allowing normal market forces to take over gradually. For the Europeans, however, it would be more than jarring to simply stop granting guarantees one clear day and to expect the market to slide back into control as if nothing had happened. Can you grant a partial guarantee? Can you grant a guarantee to only certain market participants without being discriminatory? These are questions the Europeans have now committed themselves to answering in a few months. It may come across that STRATFOR thinks the American plan is simpler, cheaper, easier and ultimately better — and to a certain degree that is the case. But the Europeans have two other reasons for going with this relatively cumbersome plan. First, the Fed will need to print a lot of currency to make the American plan work. Authority to print currency in the eurozone is held by the European Central Bank, not the member states, so this option isn't available to the eurozone states at all. Second, and far more important in the long run, going into this crisis Europe's banks were far weaker than their American counterparts, whose only real problem was subprime mortgages. Europe's banking problems are deep, structural and varied. Since a European bank crisis is the next likely chapter in this financial crisis, the Europeans are going to need a much firmer grip on their banking sector anyway. Their plan may be awkward and more expensive, but it is aiming to solve two problems, not just one.
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Geopolitical Diary: The Financial Crisis and the European and U.S. Solutions
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