Now is the time for action

How did things get so bad? The global financial system is cracking up. Banks across the world are teetering on the edge of a massive run. Equity markets are in free fall. All attempts by central banks and governments to stabilise the situation have failed miserably.

Actually, it is not a hard question to answer. Excessive risk-taking, appalling financial market regulation, and some extraordinary illusions about housing set the world up for a titanic financial disaster. Huge leverage ratios, undeserved bonuses, and years of easy credit all played their part. However, this is not the time for history lessons. We need some solutions, otherwise, another great depression really will fall down upon us. We can save the recriminations for later.

So what do we need to do? The first thing is that central banks and finance ministries need to get ahead of this crisis. There can be no more waiting around for financial institutions to poison the system.

For example, take Bradford and Bingley; the game was up for that ridiculous institution at least six months ago. However, the FSA and the treasury exhibited its usual incompetence and let the institution hang around. It only moved when a Northern rock like bank run had begun. So the first principle has to be if an institution looks rocky, deal with it straight away.

The second thing is to understand that banks need capital not more liquidity. Moreover, we are well beyond the point of any private sector solutions. Only the public sector can sort this problem out now. This means that we must start nationalising banks, so that we can pump in taxpayers money. This will be unpalatable for some, particularly those who did not benefit from the ridiculous housing bubble that caused this problem in the first place.

Therefore, those people need some assurances that we will never go through this kind of mess again. This requires several things, including stringent financial sector regulation, and a firm commitment to deal with the disastrous housing situation that now exists in the UK.

Make no mistake, the UK financial system needs a bail out. The only outstanding question is what this bailout will look like. Here we can learn much from the US. The bailout should not be a bailout of shareholders or bank managements. It should minimise the cost to the taxpayer, and should be introduced as quickly as possible to minimise uncertainty.

Third, central banks needs to rethink their liquidity operations. Central banks are now pumping in so much liquidity that they have effectively replaced the interbank market. This should come as no surprise to anyone with even a rudimentary understanding of supply and demand. Central banks are offering cheaper loans on easy terms than regular banks.

Since the price of central bank credit is typically lower than the interbank market, it should come as no surprise that the interbank market has died. Central banks need to tighten up on liquidity and force banks back towards interbank market. In the short run, some banks will end up paying higher interest rates, but this will reflect the true underlying risk that now exists within the banking sector. Eventually, this will lead to a separation of good and bad banks and eventually things will settle down.

Finally, we need to brace ourselves for a recession and a massive liquidity overhang. In the short run, a worldwide slowdown is inevitable. Over the medium term, we may see that recession compounded by accelerating inflation. Over the last year, central banks have pump in ridiculous amounts of liquidity into financial markets. While this is not yet led to a recovery in credit, it may in the long run cause enormous problems. Central banks need to plan ahead and be ready to reverse an extract this huge liquidity injection.

Frankly, I'm not hopeful that central banks and governments are up to the task. Over the last year, the authorities here in the UK, in the US and across Europe have exhibited extraordinary incompetence in handling this crisis. They seem unable to think beyond a week, to anticipate events, or plot a trajectory away from the precipice towards safety. On the contrary, they have brought us to the edge of the abyss.