What more can we do? Will it be enough?

José Mª O´Kean. Professor. IE Business School

6 November 2008

The financial crisis has led to a raft of measures by governments across the world. Most are correct but insufficient.

These are the two questions to be asked after the battery of measures we have taken to mitigate the financial crisis over the last few days. The purchase of toxic assets, the reduction of intervention interest rates to create money, the increase in the amount of deposits guaranteed by the Guarantee Fund, the direct intervention of the state in banks, assuming their commitments, the injection of liquidity by purchasing healthy assets, the injection of equity in banks with state holdings in their capital, the award of guarantees to banks so that they can fulfil their function of giving credits to families and enterprises to protect the real economy from asphyxiation, the ECB’s increase of the number of banks that can access direct finance due to the fact that the interbank market is not working...

The spectacle being written by economic history and which we are witnessing first-hand has astounded the global economic environment and created panic in a good number of individuals who have watched their real and financial wealth diminish, together with expectations for future income from their pensions.
What more can we do? In my classes I tell my students that we live in a world similar to a baroque altar. It is laden with decoration and components, but we can´t see what holds everything up. We are incapable of differentiating the structure from the surface; we only perceive the visual impact, the grandiosity of it all. I think that if we look for the essence, we encounter two problems: the value of financial assets has fallen because they were overvalued and the financial system is no longer financing the real sector of the economy due to the danger of recession it involves. In the first case, as a result of the wealth effect, families will stop consuming and start saving and, in a recession, that is the worst thing that could happen. Consumption is 60% of the aggregate demand.

Furthermore, they will mistrust any financial asset that is not very clear and will increase their preference for liquidity.

The rationing of credit by the financial system gives rise to a greater, more immediate problem: there is no finance for the consumption of durable goods, for productive investment or for buying houses, which again deteriorates the aggregate demand and involves the risk of weighing down options for future growth and rendering the productive fabric obsolete.

And, of course, the banks are in the eye of this tornado. They had grown by increasing their assets in the form of loans guaranteed by dubious assets, owing more to third-party resources than to their own and, suddenly, their assets have fallen and the third-party resources in the form of deposits have been taken from them and they have to return the debt issues they made. A lot of short-term callable liabilities and few assets and little liquidity...

In this situation, actions are being taken on every item on the balance sheet. The USA is acquiring the toxic assets whose price has fallen most as a result of the lack of transparency of guarantees, and Spain is acquiring "healthy" assets, no doubt thinking that our banks have taken part in property transactions that have been caught by the real estate sector crisis. The central banks are lowering interest rates and providing liquidity in view of the economic players´ greater preference for liquidity. Every European country is guaranteeing deposits to prevent third-party resources from disappearing from banks, and providing equity, which is ultimately the only truly effective measure. Non-callable resources are being provided to readjust the bank balance. At the same time and to again promote credit, guarantees are being awarded to help finance families and business.

But there is still something we have not considered: how to do all this in a way that ensures that the aid reaches every bank and not only the big fish, i.e. to ensure that they make interbank loans and the Euribor finally falls. It seems that we will have to take even more measures of this kind.

Will it be enough? I don´t think so. We are too involved in the financial storm and the black clouds of the real crisis are now looming on the horizon. In the case of Spain, we should approach the situation from wages agreements and a plan for improving productivity. This will help open up the horizon.

And we still have another question that has to be asked: who is going to pay for all this mess? And this is not easily answered. It will depend on the price the state pays for the assets it buys, on the percentage of capital it acquires of the banks in which it intervenes as a result of its provision and on how all this debt it will have to issue is financed.

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