Strange Days

Governments might have to intervene with taxpayers' money to shore up the financial system and prevent a "downward credit spiral" from taking hold, the International Monetary Fund said yesterday.

John Lipsky, the IMF's first deputy managing director, said: "We must keep all options on the table, including the potential use of public funds to safeguard the financial system."

The statement by the senior IMF official marks the second radical policy intervention from the IMF this year. It had previously called on governments to consider using fiscal policy to offset the impact of the credit crisis on growth.

Mr Lipsky said: "I fully recognise an appropriate role for public sector intervention after market solutions have been exhausted."

He urged policymakers to "think the unthinkable" and prepare now for what they would do if the worst case scenarios materialised and "low probability but high impact events" threatened to jeopardise global financial stability.

He warned of the risk that a "global financial decelerator" could take hold, in which rising defaults and margin calls from lenders triggered forced asset sales, driving down the value of collateral and forcing further forced sales.

The IMF deputy managing director's comments make it clear that the fund is open in principle to the possibility of taxpayer-funded intervention in the market for mortgage securities as well as intervention to save individual banks from bankruptcy.

Mr Lipsky warned: "The risks of further escalation of this crisis are rising and decisive policy action will be needed."

He said this crisis was different from recent past crises because both the financial markets and the banking system "have faltered simultaneously". The first priority had to be to reverse the "spreading strains" in global financial markets and restore the functioning of the financial system in advanced economies.

Mr Lipsky said there should be no let up in the pressure on financial institutions to disclose losses but said pressure to deleverage "needs to be kept orderly".

He also urged banks to recapitalise to avoid shrinking their balance sheet.

Stressing that this was a global problem - not one confined to the US - he said it would have to be addressed in a "global -context".

Mr Lipsky said the "first line of defence" remained monetary policy and interest rates. But monetary policy was "hampered" by problems in the credit markets and "there is a risk of a broader and more intense tightening in credit conditions".

This was why the IMF was making the case that "there is likely to be a role in some countries for stepped-up counter-cyclical macroeconomic policy measures to help support demand". Fiscal policy was the "second line of defence".

But Mr Lipsky said "macroeconomic policies may not be sufficient to cushion the blow if an extreme event occurs" - making it essential that policymakers prepared for the possible need to intervene.