From a great fall to a terrible economic winter

It is proving harder than many experts expected to put Humpty Dumpty together again.

From Tampa in Florida to Narvik in Norway, from the City of London to Astana in Kazakhstan, potentially one of the world’s richest oil producers, the American sub-prime mortgage-induced financial crisis is gnawing away at the pillars supporting financial market stability, as well as business and consumer confidence. How to turn the tide before it swamps the global economy is perplexing the best economic policymakers on the planet. Already official European and US economic forecasters are trimming back their expectations for growth next year.

It is the pervasiveness of the crisis which is now so worrying. In Florida, for example, local authorities have been denied access to centrally managed reserves in the Local Government Investment Pool, because of what amounts to a run on this (originally) $27 billion fund after it revealed sub-prime losses. Some local authorities are facing trouble paying teachers and other staff. The Pool had lost money investing in structured sub-prime mortgage bonds. Narvik is one of a group of local governments in Norway, and who knows where else on this side of the Atlantic, that has also lost money in America’s sub-prime bond market. The City of London is witnessing what financiers describe as "a severe bout of illiquidity", in the eurozone bond market. This, they say, could threaten the ability of EU governments and companies to raise money in the New Year. Europe’s money markets, too, are still not functioning properly. The European Central Bank (ECB) last week (30 November) joined the US Federal Reserve in announcing plans aimed at keeping money markets liquid through the traditionally difficult year end.

But what to do to restore confidence? As European Voice went to press the Bank of England was, on 5-6 December debating whether to give inflation a back seat and respond to demands for a cut in interest rates. Advocates of this approach say that actual money market rates are close to one percentage point above its Bank Rate and are driving the economy towards recession. On Thursday (6 December) the ECB was due to announce whether it would lower its policy interest rate. With the latest eurozone figures showing inflation running at 3%, well above its 2% target, to do so would be tantamount to self-immolation, an attack on its own credibility.

So financial markets are not expecting a reduction in the level of its main refinancing rate from the current 4% level. Interestingly Angela Merkel, the German chancellor, in an interview in Stern magazine, last week demonstrated her support for the ECB’s tough anti-inflation stance by invoking the anti-inflation credibility of the Bundesbank and described the impact of inflation on small savers as "the most perfidious form of expropriation".

But what about Washington, DC, and Wall Street, prime architects of this global disaster? The phrase "headless chickens" comes to mind. US Treasury Secretary Henry Paulson has been debating trying to persuade lenders not to raise the low ‘teaser’ interest rates which had been used by glib salesmen to lure gullible borrowers into perhaps $300 billion of mortgage loans that they could not afford. But to qualify for such a concession the borrowers would have had to demonstrate that they could not pay the interest. The trouble is that such a standard would be an open invitation to every customer to miss a couple of mortgage payments in order to qualify for continued access to cheap money. It would also frighten banks thinking about making new mortgage loans and further undermine the ratings on the bonds into which these ‘teaser’ mortgages have been packaged. US Treasury officials say Paulson is having second thoughts.

Then there is the prescription of one of Paulson’s predecessors, Larry Summers. I looked in vain in the financial market rescue strategy which Summers outlined in the Financial Times on 25 November, for a single word, "inflation". The Federal Reserve, he says, should slash interest rates to protect the financial system, ignoring the fact that US inflation, at 3.5%, is actually higher than the eurozone’s. The US government should, he said, also prepare to inject cash into the economy through the budget and ready plans to lend directly to the housing market. For Summers, the spectre of the "Great Depression" summoned up by John Stumpf, chief executive of Wells Fargo, one of America’s biggest banks, in recent comments on the state of the US housing market, seems to be more than just a bad dream.

Summers’ prescription would invite a dollar crash. Can it really be that Washington is ready to see the US currency plunge to new lows and inflation ratchet up even further? This would certainly knock the real value of America’s foreign debts, the 1 trillion of greenbacks in the Chinese government’s currency reserves, not to mention the trillions more in the coffers of oil-producing nations and Japan. But the cost to America’s battered international prestige and the credibility of its currency would be enormous. Are things really this bad?

• Stewart Fleming is a freelance journalist based in Brussels.

It is proving harder than many experts expected to put Humpty Dumpty together again.

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