United for Peace of Pierce County, WA - We nonviolently oppose the reliance on unilateral military actions rather than cooperative diplomacy.

"[Y]esterday's announcement by BNP Paribas, a large French bank, that it was suspending the operations of three of its own funds was, if anything, the most ominous news yet," Paul Krugman wrote in his Friday column in the New York Times.[1] -- "The suspension was necessary, the bank said, because of 'the complete evaporation of liquidity in certain market segments' — that is, there are no buyers. -- When liquidity dries up, as I said, it can produce a chain reaction of defaults. . . . And here's the truly scary thing about liquidity crises: it's very hard for policy makers to do anything about them." -- Le Monde (Paris), as much in the dark as everyone else, said in its Friday editorial that "the European Central Bank has taken a risk," in that the considerable dimensions of its effort to reassure markets may cause new anxiety by showing how serious it believes the problem to be.[2] -- Ironcially, "[o]utside the real estate sector in the United States, the world economy doesn't have any major problems. Economic growth is the highest it's been in many countries, emerging as well as developed; companies — including banks — are not heavily indebted and are making extremely high profits, and household payment defaults are down everywhere in the world, except in the American real estate sector. As far as the economy's fundamentals go, everything's sunny. Up till now, the globalization of finance, by spreading the risks taken by some players, seemed the best guarantee against a major crisis. The weeks to come will tell whether the leading players have been playing with fire or not." ...

In September 1998, the collapse of Long Term Capital Management, a giant hedge fund, led to a meltdown in the financial markets similar, in some ways, to what's happening now. During the crisis in '98, I attended a closed-door briefing given by a senior Federal Reserve official, who laid out the grim state of the markets. "What can we do about it?" asked one participant. "Pray," replied the Fed official.

Our prayers were answered. The Fed coordinated a rescue for L.T.C.M., while Robert Rubin, the Treasury secretary at the time, and Alan Greenspan, who was the Fed chairman, assured investors that everything would be all right. And the panic subsided.

Yesterday, President Bush, showing off his M.B.A. vocabulary, similarly tried to reassure the markets. But Mr. Bush is, let's say, a bit lacking in credibility. On the other hand, it's not clear that anyone could do the trick: right now we're suffering from a serious shortage of saviors. And that's too bad, because we might need one.

What's been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in stuff that is normally traded all the time -- in particular, financial instruments backed by home mortgages -- have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.

The origins of the current crunch lie in the financial follies of the last few years, which in retrospect were as irrational as the dot-com mania. The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans, which allowed people without the usual financial qualifications to buy houses, and the eagerness with which investors bought securities backed by these loans. But investors also snapped up high-yield corporate debt, aka junk bonds, driving the spread between junk bond yields and U.S. Treasuries down to record lows.

Then reality hit -- not all at once, but in a series of blows. First, the housing bubble popped. Then subprime melted down. Then there was a surge in investor nervousness about junk bonds: two months ago the yield on corporate bonds rated B was only 2.45 percent higher than that on government bonds; now the spread is well over 4 percent.

Investors were rattled recently when the subprime meltdown caused the collapse of two hedge funds operated by Bear Stearns, the investment bank. Since then, markets have been manic-depressive, with triple-digit gains or losses in the Dow Jones industrial average -- the rule rather than the exception for the past two weeks.

But yesterday's announcement by BNP Paribas, a large French bank, that it was suspending the operations of three of its own funds was, if anything, the most ominous news yet. The suspension was necessary, the bank said, because of "the complete evaporation of liquidity in certain market segments" -- that is, there are no buyers.

When liquidity dries up, as I said, it can produce a chain reaction of defaults. Financial institution A can't sell its mortgage-backed securities, so it can't raise enough cash to make the payment it owes to institution B, which then doesn't have the cash to pay institution C -- and those who do have cash sit on it, because they don't trust anyone else to repay a loan, which makes things even worse.

And here's the truly scary thing about liquidity crises: it's very hard for policy makers to do anything about them.

The Fed normally responds to economic problems by cutting interest rates -- and as of yesterday morning the futures markets put the probability of a rate cut by the Fed before the end of next month at almost 100 percent. It can also lend money to banks that are short of cash: yesterday the European Central Bank, the Fed's trans-Atlantic counterpart, lent banks $130 billion, saying that it would provide unlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much of their effectiveness. Reducing the cost of money doesn't do much for borrowers if nobody is willing to make loans. Ensuring that banks have plenty of cash doesn't do much if the cash stays in the banks' vaults.

There are other, more exotic things the Fed and, more important, the executive branch of the U.S. government could do to contain the crisis if the standard policies don't work. But for a variety of reasons, not least the current administration's record of incompetence, we'd really rather not go there.

Let's hope, then, that this crisis blows over as quickly as that of 1998. But I wouldn't count on it.

It comes with the globalization of finance: the difficulties of some American banks have effects on other continents. By intervening in markets to an extent unheard of since September 12, 2001, the European Central Bank abundantly proved it.

The monetary institution wanted to reassure markets facing the crisis that began in February in U.S. real estate credit. This was much needed: a few hours earlier, BNP Paribus had caused concerns among financial professionals by deciding to freeze three funds that had invested in the risky American real estate funds. For the time being, there are no buyers in the market for that sort of product, the French bank said. Its decision was all the more surprising in that one week earlier, presenting its quarterly results, the attitude of BNP Paribas was one of boundless serenity.

By intervening, the European Central Bank has taken a risk. In early August its president, Jean-Claude Trichet, sought to be reassuring and seemed to think, like his American counterpart, Ben Bernanke, that the chief risk was inflation. Today, the massive injection of cash makes one think that the Frankfurt institution thinks the present situation in the financial markets is worrisome, to say the least. This is a problem: by spreading the risk, no one seems really able to quantify it. At the end of July, the bank Natixis said the crisis was "very small": "The most that can be lost in one year is $13 billion." A trifle compared to the financial instruments in circulation, evaluated at 110 trillion euros. Nevertheless, if, as the rating agency Standard & Poors thinks, the real estate crisis in the United States looks like the worst the country has seen since 1929, reasons for being pessimistic are not lacking.

What's most important for the European Central Bank and for the other central banks, the American Fed and the Bank of Japan in particular, is to keep the financial crisis from spreading to the economy as a whole. This is one of the paradoxes of the present crisis. Outside the real estate sector in the United States, the world economy doesn't have any major problems. Economic growth is the highest it's been in many countries, emerging as well as developed; companies -- including banks -- are not heavily indebted and are making extremely high profits, and household payment defaults are down everywhere in the world, except in the American real estate sector. As far as the economy's fundamentals go, everything's sunny. Up till now, the globalization of finance, by spreading the risks taken by some players, seemed the best guarantee against a major crisis. The weeks to come will tell whether the leading players have been playing with fire or not.

--
Translated by Mark K. Jensen
Associate Professor of French
Department of Languages and Literatures
Pacific Lutheran University
Tacoma, WA 98447-0003
Phone: 253-535-7219
Web page: http://www.plu.edu/~jensenmk/
E-mail: jensenmk@plu.edu