The 1920s and 2000s are eerily similar decades. Both were characterized by extravagant wealth, extraordinarily cavalier lending by banks and hubristic over-optimism that the world had changed. The 1920s boom transmuted into slump when the US banking system collapsed. The question is whether a similar fate awaits us today.
I offer the question because it's being posed by the West's most senior central bankers. Last week the US Federal Reserve, the European Central Bank, the Bank of England and the Swiss and Canadian central banks simultaneously injected some £50 billion (US$101 billion) into their beleaguered banking systems. It is the outward signal of their profound private concern, as I have learned from those making the decisions.
Central bankers are a curious breed. They usually remain above the financial fray but get their hands dirty when it matters. They are trackers in the financial jungle, picking up signals and sounds that mere mortals simply do not. What is spooking them is that despite differing reactions to the credit crisis, all face a continuing and deepening crisis in their interbank markets -- the markets in which big banks lend billions to each other.
This, I'm told, was top of the agenda at a meeting in Cape Town some weeks ago when last week's intervention was first mooted. For two decades Western banks have expanded their lending far ahead of the growth in the Western economy, and acutely in Britain and the US. That has led to crazy lending on the high street.
Infamously, the US sub-prime mortgage market now faces up to US$300 billion in potential loan write-offs. That may sound like a lot of money, and indeed it is, but it is less than the annual profits of North American and European banks. They should have been able to take the hit in their stride. The evidence is that they have not.
The growing fear among central bankers is that the system has over-reached itself, rather as the US banks did in the 1920s. Earlier this month Paul Tucker, the Bank of England's executive director for financial markets, gave a window into their thinking when he described the risk of a "feedback loop" between the financial markets and real economy that could create a downward economic spiral.
As banks retrenched, so the economy would get weaker -- forcing another round of bank retrenchment and subsequent economic weakness.
Make no mistake, there are banks fighting for their lives. To find capital, they are turning to the only organizations with sufficient funds -- the state investment companies in the Gulf and Asia fattened by high oil prices and vast foreign exchange reserves. Two weeks ago Citigroup, the world's biggest bank, sold a share stake to the Abu Dhabi government to raise desperately needed funds; Barclays has sold a stake to the Chinese government; the Swiss bank UBS a stake to the Singapore government. They are the first of many. The financial crisis could prompt the partial takeover of the Western banking system by Arab and Asian governments. I know at least one central banker who spent the summer reading John Kenneth Galbraith's Great Crash.
The first task of US president Franklin Roosevelt after his election in 1932 was the recapitalization of the bankrupt US banks by new public agencies -- which his Republican critics decried as socialism. But it pulled the US out of its slump. Unless the Western interbank markets start functioning again soon, the question will arise as to which governments are going to bail the Western banks out of their foolishness. Will it be our own -- or that of Chinese President Hu Jintao (
Thus the conversation in Cape Town. Ominously, the first reaction to last week's injection of funds was a sell-off in the stock markets, but by on Friday there were hopes that it might have delivered some short-term relief.
The British government should be heeding central bankers' concerns. It should be publicly announcing preemptive plans to support distressed mortgage holders and distressed lenders. It should be recasting the system of financial regulation, so that banks become tightly regulated, like utilities, as a quid pro quo for government guarantees of their deposits.
Banks and building societies should be required to be much less reckless in their lending. The bill providing for the nationalization of Northern Rock should be widened to include the other banks that will require short-term assistance.
The UK should be pressing for a proper system of international financial governance and regulation.
All that requires some conviction -- which is in chronically short supply. New Labour in office has consistently genuflected to the City's interests, allowing itself to be bullied into making breathtaking regulatory and tax concessions, and thus colluding in the financial frenzy.
Now it must change gear -- and fast. Or risk the recession that the central bankers fear.
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