It's most likely too late to save the global economy from a recession. However, judging from the sudden coordinated awakening by the Group of Seven major nations to the need for "urgent and exceptional action" on the financial crisis, the world's governments and central banks finally seem determined to limit the damage. Never mind that the G-7's bold plan of action on Oct. 10 was light on specifics. Individual governments are rapidly filling in the details as they move unilaterally to address their own needs, but with the common purpose of attacking the broader problem of eroding confidence in the financial system.
Modern finance, in which a relatively small base of capital supports a much larger volume of credit, depends on three things: sufficient capital among banks, liquidity to keep funds flowing, and trust that everyone will get paid. The problem with this financial trinity is that trust is not only dependent on the first two. It also turns on human emotion. Too much fear can bring down the house.
By virtue of its immensity, the global effort to restore trust will almost certainly succeed. Governments and central banks are offering trillions of dollars in guarantees for bank loans and deposits, purchases of impaired assets, and fresh injections of capital to a frail banking sector. The Federal Reserve is now supplying unlimited liquidity through Europe's central banks, mainly in support of dollar-denominated lending between banks.
What has become evident, however, is that measures to enhance liquidity, even this year's herculean efforts by the Federal Reserve, will not by themselves impel banks to lend when their fear of default—especially by other banks—is so high. Authorities in the U.S. and abroad are focusing on what they now believe is the core problem: the massive destruction of capital caused by markdowns of troubled assets. Restoring this financial raw material is crucial to economic growth.
To that end, the U.S. Treasury has shifted its immediate attention away from purchasing impaired mortgage-related securities and toward pumping up to $250 billion in new capital into U.S. banks in return for temporary ownership stakes. This recapitalization may well mark the beginning of the end of the crisis, although progress will come slowly. It has also become clear that the rest of the world certainly has not decoupled from the U.S. economy. The U.S. is now leading advanced economies into recession, and even outperforming developing nations are at risk of a sharp slowdown. This synchronized malaise will drag out the financial market recovery.
The lack of capital has impaired both the ability and the willingness of banks to lend. The fear driving banks' reluctance shows up in the surge in London interbank offered rates, which are set daily for interbank lending in ten different currencies. That spike hurts economic activity globally, since rates on a host of financial products are tied to LIBOR, even many mortgages. By Oct. 15, LIBOR rates had fallen for three days in a row, perhaps signaling a reversal in the climb that began on Sept. 15.
Direct capital injections not only bolster trust. They offer a bigger boost to banks' capital ratios than an equivalent purchase of illiquid mortgage-related assets. For example, U.S. banks have about $1 trillion in top-grade capital covering about $10 trillion in assets, such as direct loans and securities, for a capital ratio of 10%. Economists at Capital Economics note that if Treasury bought $250 billion of impaired assets, the ratio would rise to 10.25%, by lowering the value of the assets. But by directly adding $250 billion to capital, the ratio will jump to 12.5% for the same $10 trillion in assets.
Initially, stock markets reacted enthusiastically, but investors had been building fear of a global depression into stock prices. That worry is ebbing, but the steady stream of downbeat economic data means recent actions will not likely stave off an old-fashioned recession—nor its depressing impact on future profits and jobs.