Restoring Confidence is Key

(Export Development Canada – Peter G. Hall)

News media must be ecstatic. In recent weeks, hardly a day has gone by but some major new event has hit the street. Bailouts, bankruptcies, stock market volatility and commodity prices in freefall have almost become commonplace, spurring a frenzied search for superlatives that adequately capture the unfolding story. What are we to make of the financial sector mayhem?

The chronology of recent events is well known. Concern about the broadening impact of the deteriorating U.S. sub-prime mortgage market crested in August, 2007. Prominent market watchers foresaw the demise of one large U.S. financial house, which occurred with the collapse of Bear Stearns in March, 2008. Following a quieter summer, September was a shocker. In rapid succession, Fannie Mae and Freddie Mac were seized on the 7th, Lehman declared bankruptcy on the 15th and AIG was taken over by the government on the 17th in an $85 billion bailout. The broader $700 billion U.S. bailout package was eventually approved, but not before stock markets punished the financial sector. The focus quickly shifted to Europe, with very similar results.

Most are taken aback by the speed of recent movements, which has affected confidence on a number of fronts. Internal worries about their deteriorating books led financial firms to hastily seek “rescue alliances” with steadier firms. Seeing this, market confidence ebbed, as evidenced in plunging equity values. Jitters about the stability of the financial system, together with personal wealth losses, soured broader public sentiment. And finally, recent developments have tested financial firms’ confidence in each other, as seen in the tightening of interbank lending.

Restoring confidence on all fronts is at the heart of the multiple coordinated policy actions undertaken in the past two months. While the size, speed and sums of these actions have come under criticism, they are critical to restoration of normalcy. The financial system in the past few years was much like a large reservoir, whose sluice gates were opened too wide, for too long. The flows were large, the rivers ran high and fast, and it was a wild ride. But all the while, the reservoir was steadily depleting. Water levels became perilously low, and we realized it too late.

One solution: shut the sluice gates, and allow the reservoir to replenish naturally. But that would take too long, drying up the rivers in the mean time. In financial speak, a repeat of past mistakes that proved very costly. The solution currently in progress is to fill up the reservoir as quickly as possible, enabling the resumption of normal flows. Given tight capital markets, low confidence and huge capital requirements, this is almost impossible for industry to do itself – public institutions alone have the wherewithal to replenish the system.

Will it work? Nobody knows for certain, because we’ve not really been down this road before. A rapid rebound is unlikely - but the large and ongoing public commitment to restoring the system is gradually rebuilding confidence. Banks are slowly gaining confidence in lending to each other, a necessary first step that should increase traction in the rest of the economy.

The bottom line? Confidence is currently about as low as it ever gets. But confidence rarely remains stuck in the basement, and the swift, significant and simultaneous policy actions now underway will in time quell our worst fears about the recent market turbulence.