04-08-2008

THE GLOBAL ECONOMIC CRISIS: IMAGINING THE WORST-CASE SCENARIO

Jacques Attali, formerly the top aide to French President Francois Mitterrand and the founding president of the European Bank for Reconstruction and Development, recently headed a commission for President Nicolas Sarkozy on how to make the French economy competitive. Attali's latest book is "A Brief History of the Future."

By Jacques Attali

PARIS -- In late April 2008, at a meeting of the Interim Committee of the International Monetary Fund in Washington, all of the world’s financial and banking executives seem reassured. World markets have not collapsed. The major banks seem to be withstanding the shock. World growth remains greater than 4 percent. At the end of the meeting, the executive director of the IMF, a bit disappointed at not having been able to obtain authorization to launch the great reform he yearned for, summarizes the world’s frame of mind in his closing speech.

Admittedly, he explains, the financial system is somewhat more fragile than before the subprime crisis, but the crisis is under control. He explains that CDS -- Credit Default Swaps, or contracts between sellers and buyers that protect the buyers from credit risk -- are very useful tools, despite the excesses of the preceding months. He recalls that in such a contract the buyer pays a premium based on the theoretical value of the asset. The other party, the seller, promises to compensate for any losses. He declares reassuringly that this system has enabled and will enable enormous expansion of the worldwide economy.

Banks’ exposure to speculative risk by this system is not equal to the amount of the CDS contracts, but only, he says, on the order of 1 percent of the theoretical value of the CDS contracts, or the difference between the expected value and the actual value. It amounts to saying that the risk banks incurred by using these instruments, which have caused so much fear, is less than one-quarter of the total risk they bear for their credit as a whole. It is therefore controllable. In addition, he continues, these threats to the financial system can have no impact on the industrial system, which is doing better than ever worldwide.

Finally, if the crisis, which is passing, were to resume, the resources that the central banks have to combat it exceed $7 trillion and are increasing by $150 billion per month. The central bank of China alone holds $1.6 trillion, followed by the central banks of Japan and Russia.

And yet, the very day after that meeting, a rumor is spreading in New York that the president of the largest local American bank, who had not attended the Washington meetings, has submitted his resignation.

While the big money men were congratulating themselves on the end of the crisis in the grand hotels of the nation’s capital, on Wall Street stupefaction gave way to panic. The president of the bank revealed to his board that he had just discovered that leading market trends -- which had risen much faster than expected -- were legally forcing the bank to acknowledge that losses on CDS or options contracts did not represent the anticipated 0.1 percent of the theoretical value of the contracts. They did not even represent 1 percent as the executive director of the IMF had said the previous day, but more than 2 percent. For the bank, it meant $3 trillion, an amount two times greater than the value of the bank’s assets.

The president has to admit that he has not found any discreet means in the market to bridge such a huge gap. Around the board table, everyone understands. The world’s largest bank is facing bankruptcy. This is much more serious than the case of Bear Sterns, which JP Morgan bought out earlier. No bank is large enough to step in. And there are only three solutions: bankruptcy, buyout by a sovereign wealth fund or nationalization. In the event of bankruptcy, no one would again have faith in any bank. The dollar would collapse, and no one would want to use it anymore. It would be the real end of the American economy. That leaves either calling on a large sovereign wealth fund or nationalization. They must look to public authorities for a decision.

A half-hour later, a matter-of-fact press release discloses the resignation of the bank president. His replacement announces that the bank’s losses related to these speculative financial instruments are considerable but does not provide any figures. He asserts that a solution is being worked out with federal authorities.

Overnight, the president of the United States himself summons a crisis meeting at the White House. The chairman of the Federal Reserve System explains that he does not have the means to finance such losses and that it is necessary to call upon a foreign sovereign wealth fund from abroad.

China’s central bank is willing to come to the rescue if several sovereign funds from the Gulf states bring in another $5 trillion. But such a solution would mean the end of independence for the largest American bank, and through the domino effect, the entire American financial system. The president does not want this. But there are no solutions other than nationalization, which no one recommends. How do you finance that, other than through debt or a special tax, which would further halt growth? At dawn, after nine hours of discussion, President Bush decides to ask Congress to finance this nationalization of the bank through a special consumption tax.

The next morning, on May 2, the announcement of this nationalization causes immense trauma. The entire model of a free society is being called into question. The government, which everyone was saying should pull out of the economy, is forced to get back into it, for the worse. And the taxpayer is obliged to pay for the mistakes made on the trading floor. No one even thinks of demanding that the traders repay their exorbitant bonuses. However, the press congratulates the president on his quick reaction for stopping the crisis and plugging the holes. The stock market stops falling.

But, during the day, panic returns, sustained by the craziest of rumors: What happened to the bank can happen to any bank. CNN even announces that three other banks could suffer the same fate due to the unforeseen trend in gold prices. The few American investors who are left are worried. Are their savings protected in the banks, or do they need to be withdrawn? But what to do with them? Holding cash does not make much sense in view of inflation that is starting up again. What then? Gold? But had it not reached a peak? Real estate? But it is collapsing. Artwork? But who knows how to choose them? Then, the panic subsides. No other bank goes bankrupt for the moment.

At the end of May, the patient is still sick. Consumption sinks, recession starts and employment collapses. Many indebted consumers are now also losing their jobs. They can't afford any longer to finance their credit cards, which weakens the American financial system even more.

In Mid-June, in order to boost confidence, encourage economic growth and put money back into the system, the Federal Reservedecides to send a very strong and long-awaited signal. It sets the basic interest rate to 0 percent, which means giving back substantial amounts to every indebted household. However, it is too late. The system doesn't restart. Just like Japan in the 1990s, reducing interest rates to zero has no impact on economic growth.

A month later, the day after the American national holiday, July 4, the mood of the country is at its lowest. The financial system has never been this threatened by recession, and we hear about recent risky ventures from banks that are trying to compensate for their operating losses. In order to end the new panic, the American government tries an extreme measure. It completely freezes the options market. Nobody is allowed to buy or sell for a period of at least six months -- enough time for the banks to clean up their balance sheets. It's a return to the ‘60s financial system at a time when these financial instruments didn't exist. The president himself explains that it was a simpler time when banks were at the service of industry instead of finance, and indeed their own self-interest..

Instead of reassurance, it brings again a sense of panic. Freezing options has considerably reduced the means banks have at their disposal. The moratorium triggers what has been most feared for months, a total halt of lending and a major recession in the American economy, which leads in turn to an immediate recession in China as a result of losing its main market.

The Olympic Games open in a very somber mood with tight police control due to protests against hunger that have ignited across China.

The day after the American presidential election, the new American president announces his program to end the crisis. He calls it a New Planetary Deal. The idea is for the most powerful countries -- China, Russia and other oil-producing countries -- to finance major infrastructure projects in the developing world and for American companies to build them. Because of this program, global growth increases in less than two years.

In this new world, though, a lot has changed.The global financial system has become dominated by the Chinese, who are pilingup reserves again at an even faster pace as a result of a return to rapidgrowth. Americahas returned to being a manufacturing power, including high technology. Europe has been forgotten, still trying to amend itsnon-competitive ways.

© 2008 Global Viewpoint, distributed by Tribune Media Services (4/07/08)