The solution to getting the world’s economies moving again is to turn cash, which is still out there, back into workable credit.

This article was going to concentrate on the next necessary steps of the Irish banking plan and the prospects for the budget. However, events have overtaken us. This has been the worst week in financial markets in decades.

Despite government intervention, the money markets are still frozen and the stock markets are in free-fall. Everyone wants cash, and those who have it are squirrelling it away in central banks. The central banks don’t know what to do with the stuff because the commercial banks don’t want to lend and therefore, counter intuitively, the world is without credit, despite the fact that there is no shortage of money.

Let me explain this point, as it is important to appreciate. Cash only becomes economically significant when it is turned into credit. The banks normally perform this function. They borrow cash short-term from the central bank, their depositors and their bank counterparties.

They then lend this as credit to us and to companies long term. If this source of short-term funding dries up, the banks are in trouble because their liabilities do not match their assets.

This is precisely what is happening at the moment. Banks do not trust each other. They are reluctant to lend to each other. Bank A does not lend to Bank B because it is worried about Bank B’s ability to pay back the money.

Even if Bank B starts out with a decent balance sheet, the fact that Bank A won’t lend to it provokes the very illiquidity that Bank A was unduly worried about in the first place. Following this logic, it is easy to see how the system can dry up and the crunch becomes self-reinforcing.

This also implies that recapitalising a bank now simply means good money follows bad down the plug hole. The reason for this is that, in the event of a credit crunch, the world knows that the bad loans on the bank’s balance sheets will get worse.

This means that more and more shareholders’ capital will be needed to cover these future write-downs. Therefore, investors sell bank shares, knowing that their shareholdings will be vaporised by the crunch.

Another reason for selling shares is that investors realise that the putative recapitalisations of banks by governments will come at the price of preferred shares for the taxpayer, diluting the private investor further.

Finally, the economic impact of the crunch means that profits have to fall. With no one borrowing or lending, demand dries up. As private demand is some 63 per cent of GDP in the US, no demand means no income, higher unemployment and fewer sales for companies. Fewer sales means fewer profits and, thus share prices have to fall to reflect this new reality.

The major question now is how does the world pull out of this tailspin. Many different options have been tried with varying degrees of failure. The possible reason for this underwhelming market response to government interventions is because these solutions do not solve the primary global dilemma, which is how can we turn good money back into workable credit.

The solution now has to be global rather than piecemeal. The following suggestion is the most pertinent and simple way to solve the crisis. First, the long-term stated aim of the G7 should be to create a new global banking clearing-house.

A clearing-house is a bank where all other banks can clear their debts to each other. The clearing-house stands over the loans of other banks and, for a fee, creates a mechanism by which banks can lend to each other. This is what the G7 should create this weekend.

The clearing-house plan needs to be bolstered by at least three supporting moves. First, as it will take time to set up the clearing-house, banks must be forced immediately to lend to each other. For banks that have been part-nationalised in recent days, their new shareholder, the government, can compel them straight away.

For the rest, this should be made a condition of any further state aid. The state must underwrite counterparty risk, both in word and deed.

Second, in addition to this move, all governments should follow the Irish example and – for a period of time – guarantee interbank loans and deposits. Third, the world’s central banks should open the discount window and pump as much money into the system as is needed, reducing official rates in another coordinated move simultaneously.

The US Federal Reserve made the unprecedented move of accepting banks’ commercial paper as collateral during the week. This is a brave – some might say foolhardy – move, but it underscores the meltdown in the US.

Only intervention of this magnitude can save the system now, because investors are in full flight and they are in no mood to hold anything other than cash – and cash, of itself, is not worth a penny in this crisis unless it can be converted into credit which holds its value and buys everyone time.

Even with such moves, it is still obvious that the world will hurtle into recession in 2009.The objective now is to prevent a global depression. In the US, this gradual slump has been well flagged; however, Europe is moving from solid growth to recession without the intervening slowdown bit.

In Asia, the collapse of commodity prices is telling us that demand for raw materials has plummeted, implying a sharp contraction in China and possibly the rest of Asia. Counter intuitively again, without American demand, Asia is likely to drown in a sea of its own money. The Asian central banks have billions of dollars, but their big bet was on the US motoring more than their own countries, and now that bet is off.

For Ireland, we still will need a massive recapitalisation of our banks and, if the government plays its cards right, it can use the bond market to raise the money cheaply in order to inject cash into the banks. Simultaneously, we, the taxpayers, can demand significant equity in the process. This still remains the most likely and best plan.

Timing here will be crucial. If we recapitalise the banks too early, our money will simply disappear like other shareholders’ cash. If you doubt this, just ask all the sovereign funds that lost their shirts in the US investment banks, because they refinanced too early. So the state needs to mop up when all other shareholders have been destroyed.

In addition, this bank bond can be sold on to other investors, lightening the debt burden to an already strapped state. Given that Brian Lenihan, the Minister for Finance, is facing impossibly tight budgetary arithmetic, such dexterous use of the financial markets is not only desirable, but also necessary.

While politically we will naturally be focused on Leinster House for the next 48 hours, events abroad will have as much, if not more, impact on our jobs, mortgages and income as anything the minister will announce on Tuesday.

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