The bankruptcy of Lehman Brothers disrupted the markets, leaving many institutions exposed to losses. One example was the impact on US money-market mutual funds, seen as a safe and liquid investment and in which many Americans have savings and checking accounts. On 16 September, a $64bn fund that held $785 million of Lehman short-term debt said it now had to value this paper at zero, and thus the fund's net asset value fell to 97 cents, below the norm of $1 that all funds customarily maintained. This was only the second time that this had happened to any fund in the $3 trillion sector. It suffered a rush of withdrawals. If replicated at other funds, this posed the danger of widespread national panic.
It was in an attempt to contain such fears that US Treasury Secretary Henry Paulson, former head of Goldman Sachs, announced a series of measures on 19 September, including financing to guarantee the value of money-market funds. He proposed a 'troubled asset relief program' to buy up the illiquid, impaired mortgage-related assets that were 'clogging up the financial system'. If this were done, he said, banks could resume normal financing, though they would be subject to new – as yet undetermined – regulations.
The $700bn bailout posed problems. It was unclear how the Treasury would set the purchase prices for instruments of which the value was unknown. If these were too high, Wall Street firms would be unduly rewarded for poor decisions.
Congress' negative reaction showed the political difficulties involved. After two weeks of frantic exhortation and horse-trading, legislative approval was secured on 3 October. But by then, the crisis of confidence had deepened. Stock markets around the world went into freefall, with sharp share-price declines threatening the viability of what had previously been healthy banks.
On 8 October, the United Kingdom announced a £500bn ($850m) package to support British banks, including the acquisition of equity stakes. Further national measures in other countries seemed inevitable. It was not possible to say with confidence that these would halt the turbulence and enable normal financing to resume. The risk of accidents and of large knock-on effects remained.
Broader effects
There have been predictions that the crisis will herald the end of American-style capitalism and the demise of America as a global power. However, such views seem exaggerated. The crisis has demonstrated the extreme importance of Western financial markets to the world economy, and has shown that the authorities can bring to bear huge resources in order to maintain them.
The fact that Japan and China each hold more than half a trillion dollars' worth of US Treasury securities – on top of huge other Asian investments in Western economies – underlines how much the rest of the world has at stake in maintaining the existing global financial system. It is also a reminder that no other country has the broad range of investment instruments, the (normally) deep and liquid markets and the perceived long-term financial security of the United States. The tighter regulation that will now occur will tend to bolster rather than undermine investors' confidence.
The plain truth is that nobody at this stage can predict the full consequences of the crisis, still less who will be the eventual winners and losers. The budgets of countries that are spending heavily on crisis measures will be tighter – and this will affect defence spending. Injections of government funds and cuts in interest rates create a risk of higher inflation, though reduced demand in slowing economies could counteract this.
That economic recession will hit many countries because of the drying up of credit seems a reasonable forecast – this is already occurring in some countries. But the recession's length, depth and geographical extent cannot be known.
The International Monetary Fund, in its annual World Economic Outlook published on 8 October, was relatively sanguine: while the world economy would suffer a 'major downturn', it said, a gradual recovery was expected to begin during 2009. The IMF stressed, however, that international coordination of financial and economic policies was essential.
After a year of crisis, Western leaders seemed finally in October 2008 to have grasped the need for coordinated leadership. As Robert Zoellick, World Bank President, said: 'We have seen the dark side of global connectedness. We need to navigate toward the light.'
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