If subprime mortgage defaults were a nasty cough, and trouble at
hedge funds and minor European banks were the start of a fever, the
near collapse of Bear Stearns marks the onset of chest pains. Where
before the diagnosis was influenza, pneumonia is now a possibility. But
a doctor would not panic – and nor should the public authorities with
generalised bail-outs. They should mount a programme of action to treat
the disease, slow its progress and encourage the patient.

The
credit squeeze can continue and can get worse: vulnerability abounds
and contagion could yet spread further. Equity markets are valued well
above their long-run averages relative to cyclically adjusted earnings
and the replacement cost of their assets. The US housing market and
those in other countries remain expensive relative to earnings and
rents. And in addition to leveraged hedge funds, brokers and structured
vehicles that could be forced to sell assets quickly, there are
institutions with lending facilities that must be renewed in 2008 and
2009.

More financial failures are a racing certainty. But a
sustained bear market in equities and other assets is also possible, as
is a further fall in the dollar, as indeed is a crisis in a minor
market such as Iceland. When market falls are disorderly they tend to
overshoot and prices end up well below their fair value.

The extent of the damage, however, will depend on how far financial
weakness damages the real economy, and how far real economy damage
feeds back into financial weakness. In contrast to previous financial
crises, the world’s real economy headed into this one in decent shape.
But a deep real recession, brought on by lack of access to credit,
would mean lower profits, more personal and corporate bankruptcies, and
consequent pain for a range of financial securities.

Central
banks and governments can prevent all this, if they are willing to pay
the price, by taking some or all of the problem assets on to the public
balance sheet. That could be done through outright purchases of
asset-backed bonds, cheap loans to the banking system, or government
equity injections into banks. The US Federal Reserve has already begun
to do this with its special lending facilities and rescue of Bear.

But
there is a cost to this kind of support. By socialising some of the
risk in the financial system it makes losses everybody’s problem, not
just an issue for hedge funds and banks, while if intervention halts a
necessary adjustment in the price of risk, it simply stores up trouble
for the future. It may become necessary to use the public balance
sheet, but for now it should remain a last resort, to mitigate systemic
risks such as bank failures.

What central banks and governments
do need to do is get ahead of events, head off problems before they
begin and impart a sense of confidence to the markets: something that
they have not managed since the credit squeeze began. That need not
mean wholesale bail-outs but it does mean a programme of concerted,
co-ordinated action.

Part one should be reassurance that it is
safe to trade with systemically important banks. The Fed’s action with
Bear Stearns – organising a rescue that prevents its failure but almost
totally wipes out shareholders – is a wise one. The Fed should
broadcast the message that it will help other troubled banks but only
on similar terms.

Part two is setting appropriate monetary policy
to support the real economy. Having all but promised a 75 basis point
rate cut this week, by failing to indicate otherwise, the Fed is now
obliged to deliver it. To do otherwise would be destabilising.

Part
three is some action to slow the fall in the dollar, which risks
becoming a disorderly flight, and pushing up longer-term US interest
rates in the process. Fixing the dollar would be undesirable even were
it possible but sharp, co-ordinated intervention could make selling the
US currency less of a one-way bet.

Part four should be to refill
the toolbox. The credit squeeze has been marked by ad hoc policies: the
Fed had to invent a new facility so that it could lend to Bear Stearns,
for example, because it is a broker-dealer rather than a commercial
bank. One contingency that is especially pressing in Europe is to
decide who would address the failure of a cross-border bank – something
that is entirely unclear.

Part five is to show some urgency in
dealing with the policy problems revealed by the crisis: the role of
mark-to-market accounting and the pro-cyclical effects of the Basel II
capital requirements, for example. Though all of these rules have been
adopted for good reason, some are having perverse consequences and it
may even be necessary to suspend parts of them for a time. The disease
need not be fatal but it does need aggressive treatment.