The last throw of the dice - now comes judgment day

First published in the Telegraph on 12 October 2008

As the sun sets tonight, so begin the longest few hours the financial world has ever known. We will wait in nervous silence as the time ticks steadily on towards 1am – judgment hour for the world economy. That is the moment the stock market opens in Tokyo; the moment investors serve their verdict on the biggest and most audacious international rescue plan in history.

It is a fitting, nail-biting end to the most fraught month of financial trauma on record. Or at least one hopes it marks some kind of an end. Never, even in the bleakest period of the 1930s, did the bad news come so fast, so unremittingly and with such a hideous effect on the stock market. Not since 1929 have we stared so deep into the economic abyss and found ourselves teetering dangerously towards it. It makes Black Monday in 1987 and Black Wednesday in 1992 look about as threatening as an episode of Last of the Summer Wine.

It is difficult to think how the deal unveiled by the world’s leading finance ministers late on Friday could have been more confidence-inspiring. The promise is that the Western world’s politicians will do anything in their power – including part-nationalisation of the financial system – to bring the crisis to an end.

The mistake made by central bankers and governments in the 1930s was to allow so many banks to fail that business and society ground to a halt. The significance of the deal struck this weekend is that this will not be allowed to happen again. If the deal fails, the message is that policy-makers will not flinch from nationalising the entire banking system.

A few weeks ago such a pledge would have seemed perverse in the extreme, a repudiation of the free-market capitalism expounded by Washington and London for decades. Now, it is not only sensible but the only meaningful way politicians and central bankers can prevent this crisis from spawning an economic slump even more profound than the Great Depression.

If it works, the pledge will be remembered as the most epochal deal of its kind since the Plaza Accord of 1985, which caused a historic slump in the dollar (though in reality it’s far more important than that). But even then, it may not feel exactly like success: the trauma of the past month, culminating last week in the biggest stock market falls on record across the globe, has already set in train events which will cause a recession in the Western world. There will be higher unemployment and lower wages all round. Success, in this case, is to be measured against the consequences of failure.

As impressive as the deal is, and though it ticks almost all of the boxes demanded by investors, there is no telling yet whether it will shake markets out of their downward spiral.

The financial system has quite simply broken down. In the final days of last week there were moments when even the safest, most reliable markets froze up. If the system is not yet beyond the point of no return, it is close enough that if markets do not regain some composure in the next week it probably will be.

The problem is that none of the finance ministers’ grand initiatives so far have prevented financial markets from lurching further downwards. Even the UK rescue plan – on the face of it precisely the solution to the problem, recapitalising banks and guaranteeing their funding – and the interest rate cuts which followed actually caused the panic to escalate rather than die down. Does the G7 scheme hold any more hope?

It does, but only if its big promises are borne out by action. One of the reasons the past week proved to be so torrid was that, barely hours after European leaders met in Paris last weekend and agreed to co-ordinate their financial firefighting plans, Angela Merkel unexpectedly announced a unilateral guarantee on German bank deposits. This instantly undermined the promises of EU unity and, more than anything else, caused markets to seize up in the following days. In this international crisis any signs of international disunity have been disastrous. European ministers meet again today. If they blink, and betray any sign that they will stray from the G7 pledge, it could be fatal for the financial system. Provided they don’t, and the French and Germans unveil national rescue plans which chime with the G7 accord, then there is little more they can do to boost markets.

So mired in complexity has this crisis been, so fogged in acronyms – Libor, CDSs, TED spreads and all – that until this point it would have seemed rather distasteful to make the following statement of the obvious: at its heart this crisis is not about mortgages, nor about derivatives or securitisation or whatever other mind-numbing instrument you choose to mention. It is about confidence. Quite simply, investors lost confidence in the banks. Not only that, but, certainly in recent days, they became so blinded by panic that they stopped taking rational decisions and instead sold everything they could.

We had a banking system which was so over-extended, its accounts so mismanaged, that almost every single institution came within a whisker of collapse. We had a banking system that for some reason became convinced that house prices would only go up and could never come crashing down.

The sub-prime crisis and the US housing slump were the trigger for the crisis, but it was what they revealed that was scarier still – that banks were dangerously undercapitalised. They did not have enough shareholder cash behind them to survive the bad times. For all the sticking plaster remedies from the Bank of England and the US Federal Reserve, which pumped billions of dollars of liquidity into the system, what was actually needed was a way to recapitalise banks. Which brings us back to the G7 plan, and to the radical pledges from the UK and US governments to buy shares in banks.

It will be expensive. Here in Britain the Treasury will certainly have to spend more than the proposed pounds 50 billion on the bail-out. It may eventually have to buy three times this amount in bank shares, which will cost more than the annual budget of the NHS. There are further issues with the Darling plan, but the details can wait until later. For the past week or so the financial system has needed dramatic action to pull it back from the brink. The G7 plan is not just our best hope, but one of the last we have left.