After the downgrade of the US credit rating and fears over Italy's debt crisis, are we on the verge of another financial crisis similar in scale and scope to 2008?
As in September 2008, a widespread confidence crisis could result in a liquidity crisis that, in turn, could trigger a series of insolvencies throughout the international financial and banking system.
It is time for policy-makers to recapture the spirit of international cooperation from 2008-9. Given the relatively limited room for manoeuvre of national fiscal or monetary policy, it is important to be open to the possibility that a credible bailout may come from Beijing.
The situation is extremely serious. Sovereign default is no longer the nightmare scenario for a group of small countries in the periphery of the eurozone, but a possibility, albeit still with low probability, for Italy, one of the world’s largest economies and a member of the G7. Given the size of its public debt - €1.9tr or about 120% of GDP - it is clear that Italy cannot be rescued. If Italy did default, this would set in chain the end of Europe’s single currency, with systemic effects that are largely unpredictable.
Since late 2008 countries - especially systemically important countries - have consistently shown the willingness and the ability to cooperate at times of crisis. For example, China has repeatedly offered to buy euro-denominated bonds to support Europe. While offers of help have not been articulated into a concrete programme, it is plausible that further assistance could take the form of an emergency liquidity facility similar to the one devised by the G20 at the London Summit in April 2009.
Another option, that Beijing seems to consider favourably, is to provide liquidity through the acquisition of stakes in state-owned companies. This option, however, would have limited impact as the provision of liquidity through privatisation is small relatively to the deficit gap. For Greece, a country which still has a significant number of state-owned companies, the revenues from privatisation are estimated at €28 billion, compared to the official state sector financial needs of €109 billion.
A key question is whether good money should continue to be thrown after bad. In other words, will the strategy of keeping troubled countries out of the market while they restructure their economies eventually deliver the expected results?
Surely for a country to qualify for a bailout it needs to implement the appropriate measures that should stimulate growth and eventually set public finances back on the right track? The second bailout of Greece on 21 July provides exactly this kind of framework along with the involvement of other eurozone member states in the monitoring of progress. Without this framework and the related surveillance, there would be a high risk of wasting more money on Greece. The same framework must be applied to other, larger, eurozone countries.
Crucially, however, very little has substantially changed compared to a few weeks ago. In the US the Obama administration is locked into a politically unsolvable deadlock, and Italy is run by a conflict-ridden, divided and incompetent government. The fundamentals have not radically changed. So, is anything new?
It could be the general awareness that policy-makers are running out of options. As there is little scope for accommodative fiscal policy in both Italy and the US - and in other countries as well - and interest rates are at a historic low, one wonders where support for economic growth should come from. If the tool boxes of national governments look inadequate, perhaps a way to leverage policies is through international cooperation and concerted measures.
These responses may need to go beyond the G7 and to involve the G20 as well. By working together, the G20 may show, once again, its intrinsic nature as a 'crisis committee'. Unlike in September 2008 there is a mechanism to respond to another systemic crisis, and this should avoid going back to where we were three years ago. A collapse of the eurozone is in no-one's interest, especially with the looming debt crisis in the US. This is clear to China, and to any other responsible player in this overly complicated game. Restoring confidence, and breaking the vicious cycle of negative market expectations, is now imperative.