The financial crisis has reached a critical point. The sharp decline in the stock market and its volatility dramatically make the point. More important, if less visible, the flow of credit through the banking system and the financial markets is seriously impaired—even in part frozen.
A full-scale recession appears unavoidable. Recessionary forces are apparent in other important countries and exchange rates are unstable.
Those are facts.
They are the culmination of economic imbalances, a succession of financial bubbles that have been building for years. It’s no wonder that confidence in markets, banks and financial management has been badly eroded. Without effective action, fear might take hold, threatening orderly recovery.
There is good reason to believe that the means are now available to turn the tide. The financial authorities are now in a position to take convincing action to stabilize markets and restore trust.
First of all, there is now clear recognition that the problem is international, and international coordination and cooperation is both necessary and under way. The concerted reduction in central bank interest rates is one concrete manifestation of this.
More important is the determination of the US treasury, of European finance ministries, and of central banks to support and defend the stability of major international banks. That approach extends to providing fresh capital to supplement private funds, if necessary.
Recent US legislation has provided authority for large-scale direct intervention by the treasury in the mortgage and other troubled markets. Along with increased purchases by Fannie Mae and Freddie Mac, now under government control, means of restoring needed liquidity are at hand.
Other key sectors of financial markets are now protected or supported by either the treasury or Federal Reserve, specifically by the temporary insurance of money-market funds and the direct purchase of commercial paper.
Active efforts are under way to develop stronger netting, clearing and settlement arrangements for certain derivatives, in particular the notional trillions of creditdefault swaps, the absence of which has contributed to uncertainty and large demands for scarce collateral.
None of that is easy. Some of it poses risks for the taxpayer. All of it is unattractive in the sense of large official intervention in what should be private markets able to stand on their own feet. Unattractive or not in normal circumstances, the point is that the needed tools to restore and maintain functioning markets are there.?Now?is?the?time to use them.
The inevitable recession can be moderated. The groundwork can be laid for reconstructing the financial system and the regulatory and supervisory arrangements from the bottom up. The extraordinary interventions by thegovernment should be ended as soon as reasonably feasible.
That rebuilding will be the job of another day. It must draw upon the strength of the now chastened private sector. It will require more understanding of the risks embedded in so-called financial engineering and of the perverse compensation incentives that exalted risk over prudence.
There is, and must be, recognition of the essential role that free and competitive financial markets play in a vigorous, innovative economic system. There needs to be understanding, in that context, that financial ups and downs— and financial crises—will be inevitable, even with responsible economic policies and sensible regulation. But never again should so much economic damage be risked by a financial structure so fragile, so overextended, so opaque as that of recent years.
Edited excerpts. Paul Volcker was chairman of the US Federal Reserve from 1979-1987. Comment at email@example.com