Economists clash over how correction became crisis

After much political wrangling and sleepless nights for Hank Paulson, the American Treasury secretary, the bail-out package designed to reassure investors and bring confidence back into the market was unveiled last week.

After much political wrangling and sleepless nights for Hank Paulson, the American Treasury secretary, the bail-out package designed to reassure investors and bring confidence back into the market was unveiled last week.

The $250 billion (£145 billion) plan includes a voluntary capital purchase programme whereby American financial institutions can sell preferred shares on “attractive terms” to the government to raise capital.

Also included in the plan was an extension of the Commercial Paper Funding Facility (CPFF) programme and a guarantee of all Federal Deposit Insurance Corporation (FDIC)-insured institutions senior debt, effectively underwriting the risk to bond holders.

The American Treasury follows in the footsteps of Britain and the European Central Bank, which both announced similar measures last week to shore up the troubled banking sector and thaw frozen credit markets.

Although 12 months ago such drastic actions would have been unthinkable, the two-day rally in markets that followed showed consensus to have deemed the move necessary to avoid serious systematic risk. However, while central banks might be breathing a sigh of relief, debate continues as to what turned a necessary market correction into a crisis.

Bankers who have reaped the benefits of financial innovation have borne the brunt of criticism for their greed and mercenary behaviour. While baying for blood may be cathartic the push for greater state intervention in the economy, either through regulation or nationalisation initiatives, may have exacerbated the threat of systematic failure in financial markets.

“I think that the idea that Fannie/Freddie and the Lehman bankruptcy triggered this volatility is compelling, certainly timing-wise it would appear that way,” says Keith Wade, the chief economist at Schroders (pictured, middle). “I think they were a mistake on the part of the Fed and the US Treasury which meant that the bail-out was a necessary step.”

Anatole Kaletsky, an economic commentator and journalist, goes even further than Wade and says the blame can be placed firmly at the feet of the American treasury secretary.

“The blame really lies not with the extending of credit or greed but with the unintended consequences of political actions,” he says. “Before the bankruptcy of Lehmans the US economy was moving into an ordinary adjustment. The trouble started when the US government decided to bail out Fannie Mae and Freddie Mac.”

Kaletsky (pictured, top) says that the move on September 7 to take majority shareholdings in both companies undermined shareholders by wiping out their investments. This led the market to the inevitable conclusion that struggling firms would not be able to recapitalise through share issuance and cast doubt over the value of holding shares in these companies.

What followed was a share sell-off that engulfed global markets for which the only remaining option was for governments to move in with massive capital injections.

Despite Kaletsky’s attack it remains unclear to what extent systematic risk was present before September. Fannie and Freddie had underwritten about half of all American mortgage debt and had suffered a combined loss of $14 billion before being nationalised. With the downturn in the American property market still in full swing and credit drying up an argument could be made to suggest that government action was at least justifiable to prevent a collapse.

In the aftermath of this decision, however, volatility spiked and lines of credit failed to be restored. Perhaps most damning to any defence of Paulson is that, at the point of writing, Fannie Mae has yet to require a single dollar of the $80 billion made available to it under the deal.

Not all economists agree with Kaletsky on the way in which the crisis has unfolded. Primarily the claim that it was a crisis caused, or at least significantly worsened, by politicians is a contentious one and it relies on his interpretation that the Fannie and Freddie nationalisations are key to how the crisis has developed.

“I’m not sure if this volatility can be traced backed to the Fannie/Freddie rescue,” says Gabriel Stein, the chief international economist at Lombard Street Research.

Stein (pictured, bottom) says the more recent Federal Reserve’s actions, especially in asking for $700 billion without accountability and without a preconceived plan to deploy it, have been of greater concern.

“I would direct criticism at Paulson in a number of ways,” he says. “The biggest criticism, however, is asking if the banks are insolvent, as was perhaps the case with Fannie and Freddie, nationalise them but if not then why are they giving them money?”Before the bail-out was announced money had been moving into many of these institutions. Japan’s Mitsubishi Financial pumped $9 billion into Morgan Stanley for a 21% stake in the firm and Warren Buffett, one of America’s most successful investors, bought $5 billion of Goldman Sachs common shares in September.

The merger and acquisition (M&A) activity was mirrored in Europe with BNP Paribas buying up a 75% stake in troubled bank Fortis’ Belgian and Luxembourg operations and Lloyds TSB’s government supported £12.5 billion takeover of HBOS.

Investors saw the pick-up in M&A as a welcome consolidation of the shaken banking industry, which gave hope that the banks themselves might be able to work their way out of the crisis without further government intervention. Last week’s spate of global bail-out packages, however, proved that governments themselves did not share these sentiments and although markets initially reacted positively they quickly turned proving that volatility was far from being dampened.

“The stockmarket is tanking now because people are waking up to the fact that we can’t avoid a recession and the bail-out package isn’t really very good,” says Stein. “Never underestimate the ability of politicians to snatch failure from the jaws of success.”

As global stockmarkets continue to price in worsening economic data consensus has moved to suggest that Britain is facing more than simply two consecutive quarters of negative growth but perhaps a deeper recession. Under the efficient-market hypothesis this is the direction that would have been expected given available information but if market conditions have given ample warning of anything it is never make predictions.