Storm, The (23 page)
The measures above, of varying degrees of radicalism, are designed to stimulate economies that are in recession, or worse,
and suffer lack of purchasing power because consumers have been frightened or impoverished, or persuaded by bad experience
of personal indebtedness to be prudent. Such policies are, unfortunately for politicians, counter-intuitive. It is ‘common
sense’ to believe that in bad times families should be more careful and should spend less. Having seen the country’s economy
brought to its knees by a surfeit of indebtedness and profligacy, few people outside the rarefied groves of economic academe
will easily be persuaded that it makes sense for the government to go on a spending spree or to encourage individuals to do
the same. Therein lies the ‘paradox of thrift’: that prudent saving behaviour by individuals may be collectively damaging.
Keynes may have persuaded his intellectual contemporaries of the need to confront the paradox through reflationary monetary
and fiscal policies; it is the difficult job of politicians to win that argument in a democracy.
In the latter part of 2009, as the storm appeared to be abating, the emphasis in the policy debate was shifting. Very active
monetary and fiscal policies, and bank rescues, appeared to have at least stabilised crisis-hit economies. The main economies
were moving out of recession, or at least showing signs of doing so, and they were in turn pulling up the rest of the world
economy.
The issue was becoming one of how to achieve an ‘exit strategy’: withdrawing fiscal and monetary stimulus in sufficient time
to avoid triggering a new round of reckless lending and inflation, but not too soon so as to bring back recession and a renewed
collapse of confidence. There is unlikely to be an early exit from loose monetary policies, since there is little sign of
inflation returning (except in a few countries such as Russia); central banks are still concentrated on the risk of deflation.
Were oil prices to rise sharply with global recovery, that position might be threatened, but it has not been as yet.
The main problem area is fiscal policy and large government budget deficits. State spending has been a safe haven in the recessionary
storm, but could become a major burden for some major countries. In 2009 only Saudi Arabia and Norway of the world’s most
significant economies have been running budget surpluses, and only Canada (and perhaps China and Brazil) are in a comfortable
position. Government borrowing in 2009 is likely to have reached 13–14 per cent of GDP in the USA and the UK, 10 per cent
in Spain, 6.5 per cent in the eurozone (twice the level prescribed under the Maastricht Treaty), and 7.5 per cent in Japan.
To a substantial degree, these borrowing levels are not a great cause for alarm because they reflect the temporary nature
of the economic crisis; with recovery, it is anticipated, revenues will revive and recessionary spending outlays will contract.
But there are two major residual concerns.
The first is that, in some countries, there is a big ‘structural’ element in the deficit, as when a high dependence on the
banking sector for government revenue, or a booming housing market, will leave behind a continuing deficit even in the face
of a recovery (should that recovery happen and be sustained). The UK definitely, possibly Spain, and perhaps even the USA,
are in this position. Unless there are clear plans to identify the structural element in the budget deficit and to deal with
it, there is a risk of deteriorating creditworthiness, higher borrowing costs, and a progressively more intractable budget
deficit.
The second concern is that all major countries will emerge from the crisis with much higher levels of government debt in relation
to GDP than when they entered it. For European countries and the USA, this could mean public debt to GDP ratios closer to
80 per cent than the 40 per cent they have been used to and have come to regard as prudent. That, in turn, would mean that,
as borrowing costs rise in a recovery phase, with the private sector competing for capital, debt interest payments would become
greater. This, together with the need to shift to budget surpluses as growth gets under way, could cause considerable political
strain. Countries such as Japan, which has high debt levels already, would face greatly restricted freedom of manoeuvre, which
could be especially serious if there were to be fresh shocks. These economic management issues will be compounded by the need
to fund an ageing population. After a nice decade, developed economies face a very nasty one.
The problems of macroeconomic management overlap with a failed banking sector. Having been taken to the brink of, or over,
the edge as a result of indulging in excessive leverage, and having inadequate capital to support the risks involved, banks
have been piling up capital reserves against bad debts, and restricting lending. As the Governor of the Bank of England observed
recently of banks: their behaviour is individually understandable but collectively suicidal – suicidal because they have been
dragging down the wider economy, precipitating more bankruptcies and more bad debts for the banks themselves. These problems
exist in varying degrees throughout the developed countries that experienced a banking crisis, and in countries dependent
on foreign banks.
In order to break this destructive cycle, major governments have followed a variant of the British model of bank capitalization.
Late in 2008 the UK government injected large sums – £37 billion – to provide fresh capital, as well as guarantees for inter-bank
lending. The purpose was to restore confidence in the banks by ensuring that they had enough capital to absorb any bad losses
and to facilitate new lending. Barclays raised capital separately from the government but on more expensive terms, from Arab
investors at an effective cost of 16 per cent.
A year after the recapitalization there is still no return to ‘normal’ banking behaviour. Banks have been berated for reluctance
to lend, but simultaneously have been required (by the financial regulator) to maintain strong reserves and also to repay
the government investment as quickly as possible. However much bank managers may have been guilty of irresponsibility in the
past, they now have conflicting objectives. It is the job of government to clarify which is the most important.
What else can be done? Is the only solution to wait until confidence gradually returns? The problem with waiting is that in
the meantime good, solvent companies are dragged down, along with others that are not sustainable, because they cannot renew
their lines of credit. One possibility is further bank recapitalization, but this would involve yet more taxpayers’ money,
with a continued uncertain outcome. There is a danger that the government would be drawn into a succession of recapitalizations
in order to deal with continuing crises as plunging asset prices devalue bank assets, swallowing up the capital that is put
in.
Instead of, or alongside, further recapitalization, I have argued that governments will have to treat the banks as if they
were nationalized and require them to keep lending to solvent customers, recognizing that there may be some bad debts as a
result. There is a real dilemma here. There is, on the one hand, little appetite, at least in the USA and UK, for civil servants
to take over the banking role of assessing risks as between different borrowers, or for government to take on formal financial
responsibility, as in the case of outright nationalization. In the UK, majority state ownership of RBS/NatWest and minority
ownership of Lloyds/TSB has meant that there is a narrowing debate between ‘nearly nationalization’ and outright nationalization.
The latter takes the government further, and reluctantly, into the direction of lending but it provides clarity, the means
to bring hidden bad debt into the light and an opportunity to ensure new flows of
credit (as is now, belatedly, occurring through Northern Rock). In any event, government cannot now walk away. It has no alternative
but to keep the banks performing their role of transforming short-term assets into long-term loans, until a more fundamental
reform of the banking system can be introduced after the crisis. At the very least, government nominees to the boards of rescued
banks should be directing strategy, though not micromanaging the banks.
Other steps have had to be taken to remove bad and toxic debts from the banking system. The Paulson plan in the USA was designed
to remove bad debts from balance sheets, by buying up toxic loans through market mechanisms. That particular programme hasn’t
worked well, but the concept remains valid. The UK introduced an Asset Protection Scheme to insure bad debt, but valuation
problems led to serious delays, and there are grounds for questioning the open-ended nature of the government underwriting.
The most successful programme for managing a bank crisis – through the Swedish Bank Support Authority in the early 1990s –
involved bank recapitalization but also the separation of ‘good’ and ‘bad’ assets, following the forced disclosure of problem
loans, into ‘good’ and ‘bad’ banks. The latter were actively managed in order to reduce losses, and the former prepared for
(profitable) privatization albeit after a long period of time, close to a decade. The Swedish model is not entirely applicable
today, because the crisis was limited to Scandinavia and took place in a benign international environment. But similar, successful
interventions have occurred in Israel and Korea. The key elements – recapitalization and active state management pending reprivatization
of a reformed, restructured system – provide the best template available.
There is another element in the mix: additional measures to encourage new lending, either direct lending that bypasses the
banks or, alternatively, state guarantees for new lending. As to the first, an element of this has happened already in the
USA with Federal Reserve loans to large companies. But the state cannot create quickly and competently a new structure for
lending to
hundreds of thousands of small and medium-sized companies in parallel with the banks; nor should it need to. There are also
elements of state guarantee already in the credit system, notably for export credit. This idea was adopted by the UK government
in its January 2009 proposals. But it is not just a technical fix; it has radical implications. What has been proposed is
nationalization, or part-nationalization, of credit: easier to manage institutionally than the nationalization of banks, but
creating the same – vast – degree of contingent liabilities for the state (without the potential benefit from eventual disposal
of nationalized assets) and the same responsibility for credit allocation. In the event, the clumsiness and bureaucracy of
the guarantee scheme and residual private sector risk have prevented it being extensively used. A variant of this idea, being
applied in the USA, which avoids the state being directly involved in credit allocation, is for the government to buy up loans
in the secondary market and mortgage back securities or the debt itself.
In practice, the crisis has required a combination of the above: more recapitalization of banks, forced lending, ‘bad banks’,
and lending guarantees. Different countries have evolved a different mix and approach, depending on the severity of the banking
crisis. But, in each case, the price for restoring financial stability will be a greatly increased role for the state in the
banking sector. That is, however, merely a short-term fix. After the crisis there will have to be a new regulatory regime
providing better protection against systemic risk.
After the calamities of the last year, few now question that the Anglo-Saxon model of finance was deeply flawed, unstable
and unsustainable. It will have to be remade in ways that greatly reduce the systemic risk from large volumes of excessively
leveraged transactions, but that, hopefully, preserve the capacity for innovation. There is a balance to be struck. There
is no attraction in a regime of vigorous exercise which then causes a massive
heart attack. Nor is there merit in petrified immobility because the body is permanently attached to thermometers and assorted
health-check devices.
