Follow Philippe Legrain on Twitter Follow Philippe Legrain on YouTube Follow Philippe Legrain on Facebook Email me
By Philippe Legrain ADD COMMENTS

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.

But 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. Picking up the pieces of individual banks 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 needed.

The US has opted for a $700 billion 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 bail-out 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. 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, putting taxpayers first in line to be repaid if a bank fails and giving us all a share in the profits when banks – and the economy – recover.

A government recapitalisation of the banking sector, combined with tougher financial regulation to limit future excesses, would be good politics as well as good 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 06 Oct 2008 in Blog

Leave a reply