After the US-led war, here comes the US-led financial crisis

By: Wolfgang Münchau

This is the Bush administration's financial equivalent of the Iraq war. The US Treasury-led bailout of Citicorp, the world's largest bank, and some other US banks through an opaque emergency fund, is morally wrong and economically illiterate. It will turn a bad crisis into a catastrophe. 

The fund goes by the euphemistic name of Master-Liquidity Enhancement Conduit, or M-LEC. M-LEC invests in special investment vehicles (SIV), which borrow short-term in the asset-back commercial paper market, and invest long term in the tranches of collateralised debt obligations. In doing so, M-LEC is technically similar to an SIV itself. It gets its cash from the ABCP market, and the investments go into opaque debt instruments, for which the market has dried up, and for which consequently no price can be determined. M-LEC enjoys a quasi-government guarantee, even though this is not officially admitted. Officially the banks themselves guarantee M-LEC's ABCP issues. But who in their right mind would buy ABCPs backed by US commercial banks, given that we probably do not yet know the full extent of the difficulties that they are in? Ultimately, this sordid gambit only works if through a system of hoods and winks we are led to believe that the US taxpayer will foot the bill if hove comes to shove. That, in my view, is a reasonable assumption.

 

This is about the worst policy error one could commit at this stage. Considering that the Federal Reserve has cut interest rates despite continued inflationary pressures, it is clear that the entire might of the US financial and economic policy establishment is now firmly in Wall Street support mode. But this also means that they are turning a bubble into a super bubble. The message from this latest rescue operation is that some banks are too big too fail. From the point of view of Citigroup, Bear Stearns and other US banks the logical conclusion one should draw from would be to continue to invest in securities which carry excessive risk. If the gambles pay off, their shareholders keep the profits, after the obligatory $100bn salary to the top dog, while the taxpayers foots the bill if the gamble does not pay off.

 

I would have thought, however, that US taxpayers are not that stupid. Or if they are, that there are not that stupid forever. This Ponzi game will end, except now the Ponzi is getting bigger before it ends. And that means that whatever damage it will cause, it will be even bigger. Maybe there will be another round of bailouts, and another round. But eventually any Ponzi scheme will end. We know this. The fact that the Bush administration is will play this Ponzi game suggests that this game may last another 15 month, the remaining time period for this administration. In a Ponzi game world this is a long time indeed.

 

The best that could possibly have happened is for one of these large US banks to go bust, which I assume may have been the case if this fund had not been invented. It would have caused all sorts of shocks, on the stock market, in credit markets, but it would have sent a clear signal to the markets to start thinking about a proper pricing of risky assets. This may have made the forthcoming US recession worse, but the Fed would have been able to help with monetary policy in this case, and this crisis would have eventually been over. With the right kind of policy choices, there is absolutely no need for this very serious bubble to lead to a very serious economic crisis. With ex-Goldman Sachs bankers now firmly in charge of the US Treasury, and willing to entertain new Ponzi games, just as they did in their previous jobs on Wall Street, it appears to me that this crisis is going to play out much worse that I thought (and I was not what you would call an optimist).

 

There is not that much we Europeans can do. After the US-led war, we now have the US-led global financial crisis. At first, this looks like a US-victory, until you eventually discover the depth of the catastrophe.

 

There are two important things we can, and should, do however. The first is to maintain a steady course in monetary policy unlike the Fed. In other words, maintain a policy to stabilise the rate of inflation expectations at 2%. I would consider the present policy stance to be consistent with that goal, but would not exclude further rate increases in the future if inflationary were to build up. 2. Ensure that regulatory policies are symmetric. This means that policy should not reward bad behaviour. In particular, we should not participate in the US bailout scheme, or invent similar schemes ourselves.

 

If the US bubble blows, the global financial system, and the global economy itself, will face a huge crash test. There is no way that Europe and Asia can insulate themselves against this US-led madness. But after the crisis, it is time for some serious thinking about creating efficient structures to allow us to decouple from the US in the long run. Decoupling is necessary for Europe to thrive in the long-term, but unfortunately, it is not automatic.

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