Britain is heading into a new phase of the financial crisis. The form in which this is tackled will determine whether the government’s recent increase in popularity can be sustained. It will probably also determine the outcome of the next general election.
The step to which the government is necessarily being driven by the unfolding of the banking crisis is large scale direct intervention in the banking sector. This is what Alistair Darling is referring to when he speaks of ‘big steps which we would not take in ordinary times’.
David Cameron has publically admitted the literal financial, as well as political, bankruptcy of old fashioned neo-liberal Thatcherism by now conceding in the Financial Times: ‘It is possible to imagine the circumstances in which government injections of capital, with proper safeguards and strict conditions, may be the best way to protect the long-term interests of the taxpayer.’ On Monday 6 October Royal Bank of Scotland, Lloyd’s TSB, and Barclay’s were reported by the BBC as themselves calling for the government to put capital in the banking sector.
All this amounts to the same thing - direct state ownership in the banking system. It usually promotes clearer thought to call things by their proper name. What are the economic policy principles on which such intervention should be carried out?
This development of the open crisis of the European and UK banking system has changed not only the economic but also the political situation. If the government meets this challenge effectively it can translate its advantage over the Tories - whose support for old fashioned Thatcherism is now discredited - into a reversal of its political fortunes.
The scale of the current threatened European banking collapse greatly exceeds that of Bradford and Bingley or Northern Rock. The German Hypo Real Estate, saved only by massive state intervention last weekend, is a bank with assets of €400 billion. Fortis, which is now sundered in two between nationalisation in Holland and the takeover by the French PNB Paribas in Belgium, was even larger. In Iceland the currency has plummeted, two of the three largest banks are nationalised, and its banking system is approaching a state of collapse. The 100 per cent guarantee of deposits given by the Irish and Greek governments, followed by one for retail deposits by Germany, and now by Portugal, was forced on them by the necessity to head off the threat of a run on their own country’s banks. But it has only spread financial contagion further - to stop a run on their own banks, Ireland and Greece, in effect created a run on other countries banks as depositors switch money out of countries without 100 per cent guarantees.
As such contagion cannot be contained soon the taxpayer will bear the considerable risk of guaranteeing bank deposits across large parts of Europe.
During the first wave of the financial crisis individual European banks – Northern Rock, Fortis, Bradford and Bingley, Glitnir and Dexia – were forced to accept government bail outs or rescues of different forms. In the new phase essentially the entire banking system of countries can be threatened. As the Paulson plan will not stabilise US markets the UK government must, therefore, strategically prepare to confront the next wave of crisis. How it does so will also determine its fate at the next general election.
There is now almost unanimous agreement, including even by the government, that Labour’s response to the first phase of the economic crisis, the one of increased energy and food prices combined with economic slowdown and the collapse of Northern Rock, was insufficient or too slow and therefore led to a very severe fall in the government's support.
What was actually required, faced with increases in energy prices, was a windfall tax to redirect resources from energy companies to ordinary voters suffering from the increase in heating, electricity, gas and other bills plus an increase in taxation of the very highest paid. This would have given the government ample resources to protect ordinary voters. These measures are still required and must be accompanied by a sharp reduction in interest rates – Vince Cable was, again, right in what he said on Sunday that if the Bank of England fails to cut interest rates voluntarily, and insists on pursuing the types of disastrous policies followed by former Bank Governor Montagu Norman in the 1930s, then its independence must be revoked. Large interest rate cuts are absolutely indispensable for recovery.
Labour’s political support has significantly increased in the last few weeks as it has abandoned de facto acceptance of discredited Thatcherite dogma and has acted to safeguard ordinary people in relation to HBOS and Bradford and Bingley.
To transform the government's standing in the country this approach must continue into the new phase of the financial crisis. Reduction in interest rates is absolutely vital but it will not suffice by itself. The core of this phase of the financial crisis is how to deal with the crisis in the banks themselves.
It is clear that due to the policy decisions they made large parts of the British and European banking system will become insolvent. It is because they have brought ruin on their own institutions, while paying gigantic salaries for such incompetence, that voters regard those responsible in the banks with disdain. And it is because the Tory Party is the responsible for the Thatcherite system which permitted this that political support for this party is now starting to fall as far more fundamental issues than anything seen for decades have to be confronted.
This sentiment of voters, in fact, coincides with market economics. Financial markets are to be run by those in them bearing the consequences of both success and risk: if they take the right decisions they profit, if they take the wrong decisions they lose. If those owning banks have taken decisions resulting in the value of their equity being written off that is their responsibility. When they made profits they took huge returns, therefore those who took the wrong decisions should suffer any losses, up to going bust, is the entirely aligned verdict both of market economics and voter sentiment.
This is the fundamental principle that was rightly applied in the much applauded Swedish economic bank rescue package in the 1990s which is examined in another post on this blog. As the governor of the Swedish central bank put it this package resolutely decided to: ‘enforce the principle that losses were to be covered in the first place with the capital provided by shareholders.’ It is worth repeating the points made in that post.
Those who wish the taxpayer to subsidise bank shareholders argue that such large banks 'cannot be allowed to fail'. But this is to confuse two quite separate questions.
Certainly the deposits of individual savers in the banks should be safeguarded, and this can be done by the state, i.e. the taxpayer. It may be necessary to take banks into public ownership and ensure they function, as occurred with Northern Rock and Bradford and Bingley - and Northern Rock is now one of the safest banks in the country actually turning away depositors. But the shareholders equity should not be guaranteed. Taxpayers should not be bearing the risk of wrong decisions taken by owners of private banks.
It is said that there is an upside for taxpayers if they take a shareholding in these banks. But there is also a downside - and that is a much greater risk in the present situation. Most sovereign wealth funds of individual countries that have taken positions in financial institutions in the last period, for example, have lost huge sums of money.
In any case the downside risk of taking a shareholding position can be entirely eliminated for taxpayers and taxpayer value maintained. If the value of shares in the private companies goes down to zero when they are taken over then the taxpayer cannot lose money on that particular transaction. But if any price is paid then the taxpayer has a downside risk.
If ordinary individuals wish to invest in the shares of RBS, Lloyd's TSB, and Barclay's that is their right. But the government has no right to compulsorily force people to invest in these banks by using taxpayers money to buy their shares. And it will become drastically unpopular, and risk huge financial losses, if it does so.The government has regained popularity by its firm position on Northern Rock and Bradford and Bingley. It must not lose it by taking risks with taxpayers money that is the province of private shareholders.
Naturally an economy cannot operate without banks - and no one proposes that it should. And as the private sector cannot come up with the capital necessary for UK banks to operate, the capital to maintain the banking system will have to be supplied by the taxpayer. But the government’s popularity will be decided by the principles by which this intervention is carried out.
The economic answer is simple. First, as in Sweden, the shareholders equity must bear the losses. If this allows recovery of the banks that will be to the profit of individual shareholders. If it does not do so the taxpayer should not pick up the risk that should be borne by the shareholders. The principle must be as with the Swedish central bank crisis that any policy must: ‘enforce the principle that losses were to be covered in the first place with the capital provided by shareholders.’ Shareholders not the tax payer must shoulder that risk. The government should announce that it will safeguard the deposits of individual savers and it will step in to ensure the orderly continued functioning, including lending, of any bank whose shareholder equity has been lost – as with Northern Rock and Bradford and Bingley.
It is because overall the government has taken this route during the nationalisation of Northern Rock and Bradford and Bingley, that is that it has really followed the Swedish model, that the government’s support has revived. For the government to instead use taxpayers money to take risk on banks such as RBS, Lloyds TSB or Barclays that should be borne by their shareholders will have the effect of destroying its popularity. It is wrong from the point of view of economic principle and policy. It would, therefore, also be disastrous in its political effect.