Evercore Pan Asset

It was another bruising day on European markets. German shares fell 9%, partly because the German government offered a guarantee for all bank deposits then appeared to water it down. UK shares fell 8% where the authorities said they were thinking about what further measures to take. US shares fell a mere 3.5%, a further fall on the top of last week’s despite the approval of the massive Paulson bail-out plan for the banks. Why?

Confidence has gone in the inter-bank market. The money markets, under the influence of the Central Banks, are not functioning properly. If banks cannot borrow from each other and from the money markets, they have to reduce their own lending activities. Central banks are now trying to make cash available to the banks to get things moving again, but the banks are so battered by their losses and by past attempts of the authorities to reduce liquidity that they hoard the cash, putting it into ultra safe investments, when they do get hold of some.

I have been warning for months that this is a serious banking crisis, and that the authorities need to do more – behind the scenes – to strengthen liquidity and capital adequacy, seeking private sector solutions wherever possible. Now they are doing so, the second crisis erupts. This could never be contained as just a financial crisis. Because the authorities have taken so long to get up to speed, and because they have dithered or done the wrong things, the impact of the financial crisis on the rest of the economy will be worse.

The two crises now merge. The recession that is beginning to hit shops and garages, restaurants and factories, will cut the money coming into businesses. They will need to borrow more to see themselves through the downturn, but the banks will be unable or unwilling to help. Just at the time when business needs longer lines of credit at cheaper prices to avoid large scale redundancies and closures, the banks will reduce the credit they supply and increase its price.

The pattern in the UK is now clear for all to see save the Monetary Policy of the Bank of England. Collapsing oil, food and other commodity prices will come together with squeezed margins and the price cuts required to move stock next year, so inflation in 2009 will fall rapidly from its highs this autumn. Small business will be squeezed very badly by banks who cannot lend more and by customers who cannot afford to spend more. Big businesses too will struggle to obtain the credit they need and will be cancelling expansion and other investment projects. The authorities should be fighting recession, not inflation – they lost the battle against inflation a couple of years ago but it will cease to be a problem within a few months.

What options do the authorities have? The first is to cut interest rates drastically. Australia showed the way yesterday, cutting 100 basis points off her rates, even though her economy is still enjoying the benefits of Chinese demand for her commodities. The Australian bank appreciates there will be troubled times ahead. I have been calling for a 250 to 300 basis point cut in the UK. There are now more voices backing that. Of course market rates will not snap back into line with base rates, but a big cut will help all those floating rate borrowers linked to MLR and will cut market rates to some extent. It’s bad news for savers, but we all have an interest in avoiding more bankruptcies throughout the business and personal sectors, including those of us safely paid by the state.

The second is to work behind the scenes, bank by bank, to ensure liquidity and solvency levels are up to good standards. There needs to be intelligent bank regulation and intelligent central banking, based on a better understanding of the realities of the banking and money markets.

The third is to put the public accounts into better shape. The government itself in the UK set a bad example with its PFI, PPP and other off balance sheet financing and with its big build up of debt. Transferring the liabilities of the banking sector to the taxpayer is not going to solve the problem. They will not necessarily be better managed by Ministers, and the state cannot afford to take on any more. Fiscal prudence must include caution about taking on difficult debts. The state is the lender of last resort and needs to be so. At the moment it is the main lender. It needs to wean the banks and markets off such a dependence. Buying out the banks would not remove that dependence, but make it much longer-term , and ensure the losses rested with taxpayers. At least the Bank is being cautious – if reports are correct – in demanding plenty of security for the loans it makes the banks, to protect the taxpayers. That is the least bad way to handle it.

There is no single magic bullet. The authorities – and the wider political and media establishment – should think about the meaning of the Paulson plan. For a couple of weeks we were told that if the US Congress passed the plan we would be saved, and if they rejected it we would be in deep trouble. The plan passed. The full $700 billion with few strings attached to its spending got through. Markets fell further and banking markets remained frozen. Let us hope when some of the money is released it is spent effectively and its starts to help the banks it is designed to support. In the meantime, European authorities with less money to spend should say to themselves they need to spend less a lot more effectively to start to lift the gloom. Confidence is a precious flower, only appreciated when it is wilting. No-one can be sure what words, what deeds, what events it will take to rebuild confidence. Anyone in authority today is walking on eggshells. Their words could do good or harm. Their deeds could make things worse or better. I wish them well, for all our sakes.

We continue to be cautious, awaiting clearer signs that confidence is being rebuilt before committing more to markets.