Thursday, Oct. 2, 2008
The refusal of the U.S. House of Representatives to pass the $700 billion bailout plan Monday may turn out to have been appropriate if the Congress correctly understands the priorities at hand. The issue is not whether the situation should be left to the market or whether the government should save those who lose their house due to foreclosure. The main challenge at this moment is to provide liquidity to the market, particularly to failing financial institutions.
From the experience of Japan throughout the 1990s, and also from the experience of Nordic countries, it is clear that the U.S. financial crisis is also going through a sequence of events — almost physical and also psychological — that are very similar to what happened elsewhere in the world.
The problem is that the U.S. leadership does not seem to understand exactly what happened and what lessons to reflect on, as is clear in the impulsive and almost heroic actions that they have exhibited over the last three months.
Now that the Paulson bailout plan is temporarily suspended, it may not be too late to state what I have been talking and writing about in Japan with regard to the problems of the U.S. approach to resolving its financial crisis and a possible solution to the imminent threats of meltdown of global banking systems.
There are three principles that must be observed in resolving a major financial crisis: (1) treat it as a systemic failure and do not act on individual situations; (2) know the sequence of events, so the right problem can be solved at the right time; and (3) construct a universal system later to prevent similar problems from occurring again. The U.S. government seems to be violating every one of these principles and mixing the sequence of events, hence aggravating an already dire situation.
What the U.S. needs to do under this scenario is to get help from the rest of the world in setting up a gigantic credit line, on the order of $5 trillion, to provide the necessary liquidity that will allow troubled financial institutions to come in and work on their assets and liabilities without fear of punishment and catastrophic failure.
This is similar to the "Emergency Room" that the Swedes set up in the early 1990s during their financial crisis. But the credit line should be far, far greater this time to eliminate any doubt that the liquidity will run out.
In setting up this facility, two principles should be observed. One is that the U.S. government should not be asked to print more money. It has already printed too much. One problem with Paulson's approach is that he is trying to solve all the problems with internal resources. The U.S., even before the $700 billion bailout package, had issued a lot of promissory notes that will in effect dilute the value of the dollar, a scenario that sparks fears worldwide. The second principle is that the facility should be big enough to eliminate any doubt that the money might run out.
During the Korean crisis of 1997-1998, the International Monetary Fund came in to replace the over-extended American banks. This time there is no trace of the IMF on the horizon, other than its occasional forecast of what the bad debts would be (currently at $1.3 trillion, but escalating over time).
From the U.S. perspective the IMF is too European. Maybe, but if the IMF does not work, this would be a good time to call for the establishment of a global pumping station, a place where financial institutions could come to receive an unlimited supply of liquidity transfusion until they have worked out their problems.
I stated that this facility should have at least $5 trillion because it should be large enough so people do not think it is a shallow oasis. It would seem that $5 trillion is an enormous number and unfounded. But we know that the Japanese poured in $3 trillion either in the shape of public funds or foregone interest to help their banks survive.
My personal calculation at the beginning of Japan's property bubble bursting was on the order of $2 trillion, while the government was admitting only $130 billion in bad assets in 1994. Former Bank of Japan Gov. Toshihiko Fukui admitted 15 years later that the burden of the bailout on the public was actually $3 trillion. So, while I am not in a position to calculate the right size of the liquidity facility for the U.S., any number smaller than the amount that the Japanese required would be a source of trouble. It has to be on the order of $5 trillion to $10 trillion.
The only way to get this kind of money assembled is for the U.S. to ask for donations of mercy, not only from its taxpayers but also from those who have piled up dollar-denominated instruments around the world — who will be hurt if the value of the dollar or U.S. government securities falls.
For example, China has piled up $1.5 trillion in foreign reserves through its trade surplus, which is mostly in dollars. Japan can contribute $1 trillion, which it does not need returned in a hurry. Taiwan and Russia could come up with $500 billion each, and the oil-rich Gulf states certainly could support Uncle Sam easily with $2 trillion. We can ask the European Union to contribute collectively something like $2 trillion if we make the facility available to their financial institutions. That totals $7.5 trillion, and if the U.S. adds $2 trillion to the pool it brings it close to the maximum I am talking about $10 trillion.
We are not going to lose this money. It is money on which we can even expect to earn 3 percent interest. After this liquidity facility is dissolved in three to five years time, when good banks are healthy again, donor countries can expect to receive back the amount they loaned.
For this to happen, the Bush administration will have to rethink its diplomatic relationship with quite a few countries. U.S. foreign policy has been built upon the fight against terrorism. Now Washington has to repair its relationships with some countries to gain their cooperation in the fight against financial terrorism, which Wall Street has triggered and spread around the world.
Judging by the experience of Japan, the major financial crisis will go through three phases, each requiring a different measure.
The U.S. is now experiencing the first phase, which mainly comes from the liquidity crisis. The Federal Reserve Bank has provided a credit line close to $1.4 trillion and major institutions are now at the mercy of this facility. Japan lost Yamaichi and Sanyo Securities in the first phase of crisis because they could not pull money from interbank facilities.
The second phase of the crisis comes mainly from working out the bad assets. In this phase the write-offs far exceed the equity, and financial institutions cannot raise fresh capital from the market because their share price has fallen to a meaningless level. The Long-term Credit Bank, Nippon Credit Bank and Hokkaido Takushoku Bank all failed due to write-offs on loans to failing or failed companies. At this stage, it is important for the government to inject fresh capital to let the banks revive and return to normal operation.
In doing so, the government could end up owning a bank directly or through debt-equity swap. Paulson's rescue plan is appropriate for this phase as its main purpose is to buy bad assets. But I think it could be implemented much later in the game as the more urgent need is for the banks to survive without the fear of being in a "wolf pack."
The reason for this is that we are faced with a systemic problem, not a collection of individual banks. The nature of the problem at hand is a lack of liquidity. In group theory this syndrome is known as "wolf pack." While the wolves are good at attacking the victim as a team, they have a tendency to attack the weakest of the cohort should extreme hunger prevail. The banking crisis resembles this metaphor, continuing until a few mega-banks are left.
The third phase is characterized by the massive failures of operating companies. This is because the financial institutions that have survived are under severe government scrutiny and they cannot easily extend loans to businesses, their traditional customers.
This creates a problem for companies, which have traditionally relied on bank loans for their operations. All of a sudden, a banker comes to the company and says, "Sorry, we need to close the credit line and you need to return the money to us as you are no longer bankable" (a new word they will invent to pull the money from otherwise a good company).
Japan has lost hundreds of companies, such as Daiei, its largest retailer, in phase three.
We know Japan could have come out of its mess much sooner had the government proactively, not reactively and unwillingly, faced the issues straight on. I am not sure if the Americans are addressing the right issues with the right priorities and sequence, and how long it will take to get back to "business as usual." It has taken Japan 15 years, and luckily, it is OK now as it has no further room to go down.
If you recognize that the three phases are like the law of physics (indeed it seems to me that what I have described is a general theorem of major financial catastrophe), then we should expect that the U.S. package should not be hastily worked out, but rather devised utilizing the wisdom of the rest of the world.
'Pumping station' or bust
By KENICHI OHMAE
Special to The Japan Times
Last week I discussed two key points in dealing with the U.S. financial crisis: The first was that U.S. Treasury Secretary Hank Paulson's plan to buy up bad assets is not the priority; a liquidity facility is. The second was that a "wolf-pack" psychology will prevail without a "pumping station" of liquidity to which troubled financial institutions can run and work out their assets and liabilities without fear of cash running out.
I said this pumping station must be on the order of $5 trillion for the United States alone and $10 trillion to include Europe and the rest of the world.
The U.S., nonetheless, passed the $700 billion buyout bill Oct. 4, only to find out from market reaction that the bill is not what is urgently called for. Worse, America is sending a wave of fear to the rest of the world. Now the Europeans have fallen into the wolf-pack syndrome. And this time it is not individual financial institutions at stake, but countries. Now that Ireland promises to guarantee all deposits, fear is spreading to other European countries that their own systems are not as generous.
In the 21st century, a run on the bank a la 1929 takes place in cyberspace. We witnessed two weeks ago how 10 percent of the $300 billion in deposits at Washington Mutual were drained electronically in one week. Had the savings and loan stopped its electronic banking service, a classic panic on the street would have resulted. Since it could not simply shut down the system, it ran to the government for help, but to no avail. If it had had access to the liquidity pumping station proposed last week, it could have worked out the problems and probably come out alive.
Cyber-runs on banks are what is probably happening in Britain now, as people transfer money to Irish banks and, believe it or not, to Northern Rock, a now nationalized (and hence safe) haven, as reported by BBC. A cyber-run on a bank is like a neutron bomb. You don't see it on the street, but it can kill financial institutions in days rather than years.
Although German Chancellor Angela Merkel opposed establishing a pan-European rescue package at the European summit over the weekend and accused Ireland of being self-centered, it took her only one day to change her position and announce not only the rescue of Hypo Real Estate but also plans to extend protection to everyone in Germany.
Now that the crisis psychology has spread throughout Europe, it is even more important to establish an international facility to provide liquidity — an emergency room. There must be enough money gathered there so that people do not feel it is a shallow oasis.
We should not let the Americans try to figure out what to do by themselves, because what they do immediately will impact the rest of the world. For example, in Japan we have piled up over $1 trillion in U.S. government securities (USGS). If Uncle Sam prints a massive amount of fresh greenbacks in the name of the rescue, it will devalue USGS. This is something the U.S. must recognize and face squarely, because some 45 percent of all USGS and, for that matter, greenbacks, are held by non-Americans. Declines in the value of the dollar or USGS will severely damage assets held by "wealthy nations."
So, it is in the best interest of the "have countries" to chip in to provide liquidity, rather than watch the dust settle with Americans using their mint.
This also means the U.S. needs to reconfigure its entire foreign policy. The Bush doctrine is characterized by the fight against terrorism. It seems that the rest of the world is now fighting financial terror that has spread from Wall Street. In establishing a new framework of economic and financial peace, the U.S. will have to repair relationships not only with China and Taiwan but also with Russia and Persian Gulf/Arab nations, whose help is essential in setting up the proposed liquidity facility.
Neither U.S. presidential candidate seems very familiar with the economy or the market, but it is by far the most important issue for the Americans and the rest of the world.
If America cannot come up with proper leadership in this field, it is high time for Europe and the rest of the world to take the helm — to establish the liquidity pumping station with $10 trillion in reserve. The wolf pack is staring at the next victim, the weakest of the cohort.
