Calming the panic
The current crisis is a case of financial panic that risks a self-fulfilling nightmare. Governments should guarantee bank loans to end the panic.
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The last few days look more and more like a case of financial panic.
Some markets have stopped operating because nobody seems to be willing to lend for fear of solvency of the borrowers. The fears seem exaggerated, even taking into account the reduction of growth forecasts and the exposure to the losses originated by the subprime real estate market in the US. The real economy shows signs of slowing, of course, but no sign of deep recession. The IMF predicts positive growth for the world next year (3%, slower than previously predicted but certainly not a depression). About half of the losses of banks, estimated to be about $1400 billion, have been already covered by some sort of government intervention. A panic is extremely dangerous because it could bring about self-fulfilling worsening of fundamentals. If credit to, say, the real estate sector stops, housing prices would keep falling in vicious circles of self-fulfilling expectations.
Monetary authorities have tried injecting liquidity and cutting rates, but this has not fully worked because these measures have not restored faith in borrowers. The Federal Reserve has expanded its role as a direct lender to additional institutions in the market for commercial paper, but it is not clear that the European Central Bank could do the same, and there is a limit to which kind of institution could directly borrow from central banks.
Here is a proposal. The central banks should guarantee not only deposits but also bank loans, especially in the interbank market. This measure could be temporary until the situation is stabilised. These guarantees would in large part not be used to the extent that the problem is panic rather than fundamentals. The basic idea is similar to the one underlying the need to guarantee deposits so as to prevent depositors from abandoning their role as lenders to banks. With this proposal, we would avoid banks abandoning their role as lenders to other banks.
This proposal should not be viewed as a substitute for others already discussed, like bank recapitalisation, purchase of depreciated assets like the Paulson plan, or direct intervention to subsidise borrowers in the real estate market.