A financial crisis of uncertain dimensions

The finance ministers of the European Union who meet in Porto tomorrow (14 September) for an informal two-day council have to decide what on earth to say in public about what is potentially the worst financial crisis to hit the world economy since the Wall Street crash of 1929.

President Nicolas Sarkozy of France may have been playing to the gallery, but he did not exaggerate when he remarked on 10 September: "We cannot allow a few speculators to bring down the whole international system."

Since early August the European Central Bank (ECB) and the United States Federal Reserve Board have been pumping billions upon billions into the euro and dollar money markets in an attempt to restore confidence and persuade banks to lend normally to each other. This week the ECB was at it again, injecting €75bn more into the three-month euro interbank money market to try to get funds flowing freely. The technical details are immaterial. The mere fact that, for weeks, leading private sector banks have not been prepared to lend to each other (and in some cases to lend on normal terms even to some central banks), has left the world’s financial system teetering on the edge of a precipice.

For several months this column has highlighted the warnings coming from central bankers such as Tim Geithner, president of the New York Federal Reserve Bank, Jean-Claude Trichet, the ECB president, and officials at the Bank for International Settlements, about the threats to financial stability from excessive financial market speculation. It has also criticised Charlie McCreevy, the European commissioner for the internal market, for his blithe endorsement of the ‘light touch’ regulatory regime which has served to enrich bankers and speculators in Dublin, and, of course Dublin’s light-touch ally (and competitor), the City of London. Judging from his comments in the European Parliament this week (11 September) even McCreevy is finally aligning himself with those who are a bit more sceptical about the benefits that munificent American investment bankers can bestow on the world.

Sadly, America’s poodles in London, kennelled not just in Downing Street but also in Canary Wharf, Threadneedle Street (home of the Bank of England) and the offices of the British Treasury, have also misjudged the threat. The UK financial authorities have given top priority to boosting London’s position as a global financial centre, adopting the sort of gossamer regulatory constraints which Wall Street investment banks love and playing down the need to rein in the speculators.

There are a number of quite specific reasons why the crisis now gripping the world’s financial markets is so dangerous.

One is that while it is focused in part outside the banking system or in bank-related entities (so-called ‘conduits’) whose activities are often off the banks’ balance-sheets, it has the capacity to bring banks themselves to their knees and so undermine confidence in the banking system as a whole.

Reckless speculation has already triggered the near collapse and forced the rescue of two medium-sized German banks. Everybody active in these speculative markets knows that there are still billions of unrealised losses polluting the financial derivatives sectors and so the global banking system. But they do not know either who is holding them or even how big their own financial exposure might eventually be.

A second reason is that the traditional financial crisis-management mechanisms that governments and central bankers employ (and which in the EU are, anyway, so disturbingly inchoate that they were on this weekend’s Porto agenda even before the August crisis blew up), are not up to the job. There is, as yet, not much evidence that throwing billions at the money markets, or cutting interest rates as the Federal Reserve has already done and will almost certainly do next week (18 September), is having the desired impact.

Third, this is a new sort of banking crisis. In scale and scope it is an international crisis, albeit primarily transatlantic. But the traditional international crisis management players, such as the International Monetary Fund, are sitting on the sidelines. And leading members of the Group of Seven finance ministers, while at last active behind the scenes, are so unsure what to do that they do not want to take a public stance, fearing that failure will demonstrate that the emperor has no clothes.

The best news so far has been this week’s reports that behind the scenes some of the world’s major banks are getting together to try to save themselves. It will not be easy, but it is vital that they, too, are actively and co-operatively involved. Let us assume they succeed. Then, if Republican Federal Reserve Chairman Ben Bernanke does not make the situation worse by repeating the grotesque error of his ‘neo-con’ predecessor Alan Greenspan in slashing interest rates too aggressively, which would trigger a dollar crisis, two big challenges lie ahead.

The most immediate will be to cope with the impact of the - badly needed - recession now emerging in the US economy. In the longer term lies the task of learning the right lessons for financial market public policy.

• Stewart Fleming is a freelance journalist based in Brussels.

The finance ministers of the European Union who meet in Porto tomorrow (14 September) for an informal two-day council have to decide what on earth to say in public about what is potentially the worst financial crisis to hit the world economy since the Wall Street crash of 1929.