When the Beatles broke up in 1970, John Lennon used his first solo album to get things off his chest. Heavily influenced by the primal scream therapy he had been undergoing, the record included a song called God, in which Lennon trotted out a litany of things he no longer believed in. It was a long and eclectic list including Buddha, magic, Kennedy, yoga and — of course — the Beatles. The song ended with a simple statement: the dream is over.
For the US, too, the dream is over. The past week has seen the nation bellow out its own primal scream of rage at the idea of a big, blank check for the financiers who got the US into its current predicament. Judging by the reaction to US President George W. Bush’s administration’s emergency stabilization bill, the list of things Americans no longer believe in is as long as Lennon’s: Wall Street, bail-outs, Congress, US Treasury Secretary Henry Paulson, House Speaker Nancy Pelosi — you name it.
This reaction is understandable. For the US$700 billion earmarked to buy up Wall Street’s toxic waste, the US government would currently be able to buy Bank of America, Citigroup, Goldman Sachs and Morgan Stanley, lock, stock and barrel, while leaving itself with US$100 billion or more to put by for a rainy day. Even worse, the Paulson plan isn’t even a particularly good plan since it fails to address the real problem of the US banking system.
One response to the blatant deficiencies of the Paulson plan has been to say that the world would be better off without a plan at all, because the only way to purge the system of its rottenness is to allow the market to decide which banks are fit to survive. Paulson briefly tried this strategy last month when he allowed Lehman Brothers to go bust; the subsequent mayhem means the “creative destruction” thesis now finds few takers in finance ministries and central banks around the world. There is a more sensible way forward, but it requires three things to happen.
The first is for policymakers and banks to recognize that it is neither possible nor desirable to recreate the global financial system as it existed prior to August last year. Paulson appears to think it is possible to put Humpty Dumpty back together again, but it isn’t. There is no pain-free solution to the crisis and those policymakers, like the British Chancellor of the Exchequer Alistair Darling, who have been prepared to say so, will be proved right. Central banks have pumped dollars, euros and pounds into the markets to precious little effect. The reality is that finance became too big and too powerful; a reduction in its size is now inevitable as the previous excesses are worked off. When the dust settles there will be fewer banks and they will be behaving more cautiously.
The second requirement is to come up with proposals that address the real issue: that the banks badly need new capital to repair balance sheets battered by the losses on their dodgy investments. For too long policymakers approached the crisis as if they were dealing with a cashflow problem that could be solved by flooding financial markets with liquidity. The penny has dropped that this is a matter of solvency.
That’s why there is suddenly interest in what Sweden did in the 1990s to recapitalize its banking system.
The Swedes took a hardnosed view of which banks were viable and which weren’t, then used a tough love policy toward the institutions deemed fit to survive. The state took an equity stake in the banks to ensure that the public was not simply writing blank checks, put all non-performing loans into a “bad bank” that was given the task of recouping the taxpayers’ money and gave a blanket guarantee to depositors but not shareholders. The merits of the scheme were that it was a “something for something” deal for Swedes, the taxpayer was protected and it allowed the government to have a say in how the post-crisis banking sector would be organized.
Those working in the financial markets are now resigned to some form of state ownership.
“The endgame,” said George Magnus of UBS, “must include recapitalization, including nationalization, in our view.”
Governments should not blow this golden opportunity. State-backed recapitalization gives them the opportunity to reconstruct a more sober banking system.
But recapitalizing the banks is not going to work if a prolonged recession adds to their losses. Across the G7 industrial nations, the outlook is grim and getting grimmer, so the third leg of the recovery plan means a recognition that a lack of growth — not inflation — is the real threat. Those critics of the Paulson plan who say it would be better to spend the money trying to keep struggling mortgage-payers in their home have a point. But monetary policy also needs to be eased, and the sooner the better.
Cuts in interest rates do not work overnight, particularly in the current circumstances, where the bursting of the housing bubble means property prices will continue to fall. But central banks risk turning recession into depression unless they recognize the need for cheaper money. In the UK, the recent data on the economy has been abysmal, with dire reports from housing, financial services, construction and manufacturing, and there is a strong argument for a half-point cut in interest rates.
Some believe this would be counter-productive because it would lead to a sell-off in the pound and higher imported inflation. That seems unlikely; the reason sterling has been weak is that markets are worried the UK is standing on the edge of the economic abyss; the prospects of a less severe downturn would boost the pound. Nor is there the remotest possibility of lower interest rates re-inflating the housing bubble or leading to a splurge in credit.
Cheaper money is needed to prevent banks imploding and unemployment exploding; without it there is a risk of a Japanese-style crisis that drags on for years.
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