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Global crisis: how far to go? Part III

By Scott MacDonald - posted Tuesday, 21 October 2008

Lingering hope that by some ad hoc measures Europe could isolate its economies from the financial cyclone battering the US came crashing over a week ago. Amidst indications that stability of top Western banks have sunk below many in the developing world, European leaders frantically worked to devise solutions to prevent economic collapse. Denial about the totally interconnected economic life of today’s globalised world is no longer possible, but new battle will begin about the shape of capitalism to emerge from the present ruin.

Alarm bells started ringing with the stunning collapse of the Icelandic banking system in early October, leaving the island nation of 320,000 with prospects for an economic contraction of about 10 per cent and likely dependence on the International Monetary Fund for its survival until recovery starts. As central bankers and finance ministers scramble for solutions, Europeans are bewildered, worried and mistrustful. It’s obvious that failure to restore confidence will result in ongoing descent into a 1930s-like crisis, pulling along a train of severe macroeconomic and sociopolitical consequences.

The stark reality facing many European banks and investment and pension funds is that they bought many of the same toxic financial products that sank US financial institutions.


In other cases, European banks overextended in lending to local real estate markets and to Central and Eastern European markets. Consequently, slowing economic growth; tighter credit, as banks were quick to reduce lending; and extended evaporation of interbank lending, where banks lend to other banks, functioned much like a brake to a rapidly moving car. Interbank lending, in particular, became an acute problem, forcing the Bank of England, the European Central Bank and others to pump euros and pounds into the markets to guarantee some degree of liquidity.

Markets continued to be unstable, but unlike the rapid US acceptance of a $700 billion program to buy troubled assets from banks and implementation of the Federal Reserve program to purchase commercial paper, European governments remained adverse to a single policy response.

French President Nicolas Sarkozy briefly suggested the idea of a €300 billion, or US $460 billion, bank rescue fund. This was, however, rejected by German Chancellor Angela Merkel, leaving the European Union with a commitment to protect the financial system, but little else. As one commentator noted, the EU had “a common market with no common rescue plan.”

Lack of a broad, over-arching EU policy failed to calm investors or stop the crisis. In rapid succession, but in haphazard fashion, the largest Benelux financial conglomerate Fortis was rescued by joint Dutch, Luxembourg and Belgian intervention; the UK government intervened in the troubled building society Bradford & Bingley; the German government helped cobble a rescue loan for Hypo Real Estate.

When these measures failed to stem the rising panic and the German government was forced to pull together yet another rescue deal for Hypo Real Estate, Fortis was sold to BNP de Paribas in Luxembourg and Belgium and nationalised in the Netherlands, and Dexia, the world’s largest lender to local governments. The dangerous risk of the financial crisis to the rest of the economy was evidenced by Dexia’s troubles. A failure by Dexia would have threatened €290 billion of commitments with local governments. The danger of local governments losing ability to finance development would be a problem in much of Europe, with a major impact on citizens’ daily life.

What’s evolved in the European Union is a rush by member states to create their own bank-rescue and depositor-protection plans. Along these lines, Ireland moved first to guarantee deposits in all personal bank accounts as well as backing debt of its banks. Other European countries followed out of fear of losing their bank deposits to Ireland’s safer program. In addition, Spain announced a €50 billion plan to buy assets from its banks, hoping to nudge open credit markets.


In the UK, growing concerns over losses at such large institutions as the Royal Bank of Scotland, Halifax Bank of Scotland, Barclays and others saw the government resort to a partial nationalisation of some of the country’s largest financial institutions. The Brown government implemented a program with as much as £50 billion, or $97.2 billion, to buy preferred shares in banks to boost capital. In addition, the government raised the level the Bank of England makes available for banks to borrow to at least £200 billion. France and Italy also created bank-protection programs, and Germany soon joined in with €400 billion in loan guarantees, providing as much as €80 billion to recap banks, and setting aside €20 billion in its budget to cover potential losses from loans.

Despite the plethora of European government programs, investor confidence may remain elusive for two reasons - the large costs of financial bailouts and concern over the possibility that one of Europe’s large transnational banks fails.

The International Monetary Fund estimates that total losses and write-downs from the credit crisis will amount to $945 billion, and there are higher estimates in excess of $1 trillion. Thus far, according to Bloomberg calculations, total losses are $633 billion, with $383 billion in the Americas, mainly the United States; $225 billion in Europe; and around $25 billion in Asia. Chances are that the European losses will grow, possibly approaching the same level as the Americas.

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Reprinted with permission from YaleGlobal Online - - (c) 2008 Yale Center for the Study of Globalization.

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About the Author

Scott B. MacDonald is a senior partner and head of research at Aladdin Capital Management, LLC, in Stamford, Connecticut, and currently writing a book on Asia and globalisation.

Creative Commons LicenseThis work is licensed under a Creative Commons License.

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