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Tony Blair once said that the government was best when it was boldest. Gordon Brown is – finally – heeding that advice. The government’s three-pronged plan to shore up Britain’s banking system is bold and right. It is our best hope of pacifying the financial panic, getting credit flowing through the economy again and thus avoiding a 1930s-style depression.

The Bank of England’s half-point cut in interest rates is also welcome, particularly since it was co-ordinated with other central banks. It signals that the US and Europe are finally acting together to tackle the global financial crisis. But a larger cut is needed soon: at 4.5%, UK interest rates are still far too high.

The bigger challenge is to get banks lending again – to each other, to companies and to individuals. They need enough cash to conduct their day-to-day operations; secure access to medium-term funding; and extra long-term capital to provide a cushion against bad debts and allow them to lend to creditworthy borrowers.

The government’s plan addresses all three of these needs. The Bank of England will supply £200 billion in short-term funding; the government will underwrite £250 billion of medium-term finance; and it will also inject £25 billion in long-term capital initially – and perhaps up to £50 billion in total – in the form of preference shares that pay a fixed return and protect taxpayers’ investment.

Headline writers may describe the government plan as a £500 billion bailout, but that is completely misleading. The £200 billion consists of short-term secured loans; the £250 billion is a form of insurance, for which the government will be paid a premium; and the £50 billion is an investment that pays a return. This is not money for nothing. And while it is certainly true that taxpayers’ money is at risk, we will also share in the upside when the banks recover – as they are much more likely to do thanks to the government’s intervention. Most importantly, the risk of doing nothing – or of continuing to do too little, too late – is far greater. By keeping the UK banking system afloat, we are giving the economy a life raft. 

Many of the details of the government’s plan are still unclear. Ideally, the preference shares should pay a hefty interest rate to properly compensate taxpayers and give banks an incentive to seek private financing if and when they can. Taxpayers’ money should also come with strings attached, such as guarantees that banks will use the extra capital to lend to small businesses and individuals rather than pay extravagant dividends and unjustified bonuses. And, of course, the plan must be implemented speedily and efficiently.

We are by no means out of the woods yet. Global financial markets are in turmoil; other governments need to follow Britain’s bold lead soon. The UK economy has many other weaknesses: consumers are overladen with debt, often secured against housing that remains overpriced; unemployment is rising; food and energy prices remain painfully high; and the global gloom is hardly auspicious for exporters, despite the fillip of a weaker currency. What’s more, the banking package will swell the government’s already-large deficit – although borrowing to invest in banks need not increase the national debt in the long term.

But while 2009 will no doubt be unpleasant, the government’s actions should stave off economic collapse. Amid all the gloom, that is certainly good news.

Posted 08 Oct 2008 in Blog, Britain, Economics, Finance

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