Last month, when the U.S. Treasury Department allowed Lehman Brothers to fail, I wrote that Treasury Secretary Henry Paulson was playing financial Russian roulette. Sure enough, there was a bullet in that chamber: Lehman's failure caused the world financial crisis, already severe, to get much, much worse.
The consequences of Lehman's fall were apparent within days, yet key policy players have largely wasted the past four weeks. They'd better do something soon – in fact, they'd better announce a coordinated rescue plan this weekend – or the world economy may well experience its worst slump since the Great Depression.
Let's talk about where we are right now.
The current crisis started with a burst housing bubble, which led to widespread mortgage defaults, and hence to large losses at many financial institutions. That initial shock was compounded by secondary effects, as lack of capital forced banks to pull back, leading to further declines in the prices of assets, leading to more losses, and so on. Pervasive loss of trust in banks, including on the part of other banks, reinforced the vicious circle.
The downward spiral accelerated, post-Lehman. Money markets, already troubled, effectively shut down.
The response on the part of the world's two great monetary powers – the United States, on one side, and the 15 nations that use the euro, on the other – has been woefully inadequate.
Europe, lacking a common government, has been unable to get its act together; each country has been making up its own policy, and proposals for a unified response have gone nowhere.
The United States should have been in a much stronger position. And when Paulson announced his plan for a huge bailout, there was a temporary surge of optimism. But it soon became clear that the plan suffered from a fatal lack of intellectual clarity. Paulson proposed buying $700 billion worth of “troubled assets” from banks, but he was never able to explain why this would resolve the crisis.
What he should have proposed was direct injection of capital into financial firms: The U.S. government would provide financial institutions with the capital they need to do business, thereby halting the downward spiral, in return for partial ownership. When Congress modified the Paulson plan, it introduced provisions that made that possible, but not mandatory. And until three days ago, Paulson remained resolutely opposed to doing the right thing.
But on Wednesday the British government, showing the kind of clear thinking that has been all too scarce on this side of the pond, announced a plan to provide banks with 50 billion pounds in new capital – the equivalent, relative to the size of the economy, of a $500 billion program here — together with extensive guarantees for financial transactions between banks. And U.S. Treasury officials now say that they plan to do something similar.
The question now is whether these moves are too little, too late. I don't think so, but it will be alarming if this weekend rolls by without a credible announcement of a new financial rescue plan, involving not just the United States but all the major players.
Why do we need international cooperation? Because we have a globalized financial system in which a crisis that began with a bubble in Florida condos and California McMansions has caused monetary catastrophe in Iceland. We're all in this together, and need a shared solution.
Why this weekend? Because there happen to be two big meetings taking place in Washington: a meeting of top financial officials from the major advanced nations on Friday, then the annual International Monetary Fund/World Bank meeting today and Sunday.
If these meetings end without at least an agreement in principle on a global rescue plan, a golden opportunity will have been missed, and the downward spiral could easily get even worse.