As we return to work this Monday morning, let the words of the director general of the International Monetary Fund, Dominique Strauss-Kahn, ring in our ears. Mr Strauss-Kahn, having spent all Saturday with finance ministers in Washington, warned that the global financial system has been pushed "to the brink of a systemic meltdown". And he added that the measures taken thus far to deal with the financial crisis "have not yet achieved the goal of stabilising markets and bolstering confidence".
I stretch "systemic" to mean that we are all affected by what has begun to happen – the shrinking of bank credit. Banks won't even lend to each other, let alone to the rest of us. In a sense, they know too much. Grimly aware of the substantial amounts of dud loans on their own books, following a prolonged period of over-optimistic lending, they assume the worst of each other. They also turn down highly respectable companies, the mainstays of the economy, when they come to them for credit. For as the banks' mistakes return to haunt them, they feel compelled to hoard cash.
Two weeks ago, for instance, I was on the executive floor of a large company, a household name for generations. Decent people run it. It makes substantial profits. I found the directors stunned to discover that they could no longer go on raising short-term loans from time to time to balance out the ebbs and flows of their cash flows. This was a "first" in the company's long history. From now onwards, the directors would have to run their business more cautiously. They will provide less employment and reduce the orders they place with outside suppliers.
Systemic, because virtually all businesses have some borrowing. Credit is the oxygen in the system. Take it away and businesses begin to falter. They become like climbers at high altitudes. An example is the plight of local authorities and charities whose funds have been trapped in insolvent Icelandic banks. Some of these lenders will have difficulty in paying their bills and so they will unwittingly harm others who know nothing of Icelandic banks.
Systemic, seeing that the United States, Germany, Japan and most large economies are feeling the effects. Last week, for instance, shares in General Motors crashed to their lowest level since 1950. Yes, since just before the company launched the first ever "American" sports car, the Chevrolet Corvette, with its white paintwork and red upholstery. Over 50 years later, General Motors' customers are having increasing difficulty in obtaining car finance. And the stock market was spooked by the fact that loans raised by General Motors itself, already classified as "junk" debt, are to be down-rated even further – to sub-junk, I suppose. In these circumstances, virtually nobody will lend to this giant.
"Meltdown," in Mr Strauss-Kahn's phrase, is not an exaggeration because depriving the economic system of credit would quickly result in prolonged recession, or depression, call it what you will. Stock markets suddenly began to sense this possibility last week. That is why investors rushed for the exit.
Indeed, it is not fanciful to make comparisons with the Great Depression, which started with the stock market crash of 29 October 1929 and ended some time in the late 1930s. President Roosevelt's chairman of the Federal Reserve, Marriner Eccles, tried to sum up its essence in his memoirs published in 1951. He had led the Federal Reserve from 1934 to 1948 and seen everything. I quote him extensively because of his sudden relevance: "This is what happened to us in the Twenties," Mr Eccles wrote, "We sustained high levels of employment in that period with the aid of an exceptional expansion of debt outside of the banking system (which) increased about 50 per cent. This debt, at high interest rates, largely took the form of mortgage debt on housing, office, and hotel structures, consumer instalment debt, brokers' loans, and foreign debt."
Before going further, notice the similarities between then and now – the presence of mortgage debt and of shadow banking – what Mr Eccles called debt outside the banking system. Mr Eccles went on: "The stimulation to spend by debt creation of this sort was short-lived and could not be counted on to sustain high levels of employment for long periods of time ... The time came when there were no more poker chips to be loaned on credit. Debtors thereupon were forced to curtail their consumption in an effort to create a margin that could be applied to the reduction of outstanding debts. This naturally reduced the demand for goods of all kinds and brought on what seemed to be overproduction, but was in reality under consumption when judged in terms of the real world instead of the money world. This, in turn, brought about a fall in prices and employment ... (finally) the vicious circle of deflation was closed (with) one-third of the entire working population unemployed. This then, was my reading of what brought on the depression."
It has long been fashionable to say that this can never happen again because this time we know better than to let banks actually crash – that is, apart from Lehman Brothers a few weeks ago, whose collapse had had such serious consequences. Nor would governments savagely hack into public spending as they did in the early 1930s – though there are plenty of reasons in 2008 to cut back. Nor would we lapse into protectionism again – in spite of increasing temptation to move in that direction. We know what not to do. But do we know what to do?
"On the brink," observed Mr Strauss-Kahn, a clear reference to the failure of the Group of Seven industrialised nations to decide anything definite at their meeting on Saturday. But since then, I am glad to say, the pace has quickened. There are three encouraging developments. This morning, we are likely to learn which British banks are to get money under the UK Government's £50bn bank rescue. These may well be HBOS and Royal Bank of Scotland.
The Bush administration has quickly embarked on an overhaul of its own strategy for rescuing the foundering financial system. Having two weeks ago persuaded Congress to let it spend $700bn to buy distressed securities tied to mortgages, the White House has decided in addition to follow Britain's approach. The US government would inject capital directly into the nation's banks. Finally, the French government also appears to be moving towards the British solution, expressing a willingness to guarantee banks' short-term borrowings as well as their deposits.
As an international civil servant rather than a finance minister with daily politics to consider, Mr Strauss-Kahn may have felt that he should issue the dreadful warnings that others dare not proclaim. Governments won't even use the word "recession" when it is staring them in the face. And while the weekend's developments have by no means achieved "the goal of stabilising markets and bolstering confidence", they do represent progress of a kind.Reuse content