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The time for half-measures is over. Britain is no longer in the grips of a credit crunch or even a financial crisis; it is suffering a full-on financial heart attack. Markets have seized up.
Banks will no longer lend to each other. Credit to companies and
individuals is drying up. Unless credit starts flowing again soon, a
nasty recession – conceivably even a depression – looms and with it,
massive job losses, bankruptcies, repossessions and a sharp fall in
living standards. The government needs to act – now.

But what to do? Ken Livingstone, Seumas Milne
and others argue that the government should turn its back on market
economics. Since capitalism seems to be collapsing under the weight of
its internal contradictions, the government should finish it off. More
measured voices such as the TUC’s Brendan Barbour
favour a ragbag of measures, such as a new industrial policy. But all
of them are missing the point. Righting the huge problems in financial
markets certainly requires decisive government intervention, but
lashing out at generally well-functioning product and labour markets is
perilously misplaced. The last thing a heart-attack victim needs is to
have a healthy leg amputated. The priority now is tackling the
financial crisis; everything else is a dangerous diversion.

while the government should not try to turn the clock back to the
1970s, it does need to change course. Its ad hoc approach will no
longer do. The nationalisations of Northern Rock and Bradford &
Bingley, and the government-orchestrated rescue of HBOS, were justified
at the time. But damage limitation is no longer enough – not least
since Lloyds’ rescue of HBOS seems to be dragging it down, too. Now
Royal Bank of Scotland seems under threat; Barclays may be next in
line. Waiting for the next bank to collapse and then picking up the pieces will not restore confidence or get credit flowing around the economy again.

Across Europe,
governments are rushing to following Ireland’s lead and guarantee
(nearly) all deposits in the banking system. Here, the Treasury has
just raised the guarantee on savers’ deposits to £50,000. But while it
may soon be forced to extend a broader guarantee, this will not tackle
the root causes of the crisis: a lack of capital in the financial
system and sheer panic.

A cut in interest rates would do some good.
Although inflation is well above the target rate of 2%, the Bank of
England should slash rates when it meets on Thursday. As the global
economy tanks, oil prices are sinking, so inflation is set to fall.
Collapsing demand means that the real threat now is deflation, not
inflation. But a big cut in interest rates will not be enough. If banks
are unwilling to lend, monetary policy alone is virtually useless – in
Keynes’ words, it is like "pushing on a string". Bolder measures are

The US has opted for a $700bn bailout. In theory, taking
bad debts off banks’ books should reassure markets that that they are
not about to go bust. Banks may be willing to lend to each other again,
their share prices may recover somewhat, and investors – not least
Asian governments and those of oil-rich states – may be willing to pump
some of their huge cash reserves into them. But the bailout route is
deeply flawed. It provides the most help to the banks that made the
biggest mistakes. It exposes taxpayers to huge potential losses. And it
does little to recapitalise the banking sector and thus encourage it to
start lending again.

There is a better way. As now seems likely to happen in some form, with the chancellor’s statement on Wednesday morning, the government should buy stakes in – and in some cases, take over – stricken banks, an approach that worked well in Sweden
in the early 1990s. With the government standing behind banks, the fear
that they are about to go bust would vanish. An injection of taxpayers’
money would strengthen banks’ balance sheets, allowing them to start
lending again. But it would not be money for nothing: the government
could acquire preference shares, which pay a hefty interest rate and
put taxpayers first in line to be repaid if a bank fails. These could
be combined with warrants (basically, options to buy shares at a future
date at a specified price), so as to give us all a share in the profits
when banks – and the economy – recover.

John Hussman, a US analyst and investor, has suggested
a novel variant of this idea. He proposes that the government provide
capital in the form of a "super-bond". This would be subordinate to
deposits, and so could be counted as capital. But if a bank went bust,
taxpayers would be repaid before shareholders and senior bondholders,
thus protecting the financial system, customers and taxpayers. The
super-bond could pay a relatively high interest rate to give banks an
incentive to shift to private financing when conditions improve, but
interest payments could be deferred until banks were profitable so as
not to drain their cash reserves now.

A government
recapitalisation of the banking sector – combined with much tougher
financial regulation to limit future excesses – would be good politics,
as well as sound economics. With Labour so far behind in the polls, its
only chance of recovery depends on rescuing the economy from the worst
crisis since the 1930s. Decisive action would marginalise the
Conservatives, who are unconvincing advocates for state intervention in
the financial system and are, in any case, powerless to act. And since
even David Cameron has been forced to concede that government injections of capital may be needed, the government has political cover to act.

Gordon Brown has shown that he can be bold when circumstances demand it. Now is such a time.


Posted 09 Oct 2008 in Published articles

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