Storm, The (8 page)

A key step was to recognize – based on long-established, nineteenth-century practice – that banks should have whatever liquidity
is necessary from the central bank (albeit at a penalty rate and secured against sound collateral). In an effort to prevent
a crippling squeeze in credit the US administration pumped $180 billion into money markets to offset the hoarding of cash
by frightened institutions, and other central banks followed. Short-selling was banned so as to take the immediate pressure
off bank shares; short-selling had been threatening the system by driving down bank shares to the point of disabling the banks’
ability to raise capital themselves.

But the crucial step was the recognition that, if the banks were to return to their central role as financial intermediaries,
they would need help in adjusting to the large losses that they had made. Writing off losses required capital. Capital could
no longer be raised, unaided, from the markets through the normal mechanism of rights issues to shareholders, and new sources
of capital (such as sovereign wealth funds) were wary or very expensive. There was a danger that banks would try to realize
capital by drastically cutting their lending, with profoundly damaging effects on the real economy (or else try to conceal
the problem, as the Japanese banks had done in the 1990s, which would perpetuate the lack of confidence). The issue, then,
was how best to help restore the banks’ balance sheets to health.

The first attempt to grapple with this problem was the Paulson plan in the USA, to set up a fund of $700 billion to buy up
‘toxic’
mortgage-related securities from the banks. It soon became clear that market confidence generally – as reflected in a highly
volatile and collapsing stock market – hinged on getting the plan accepted by Congress. It was, however, a badly conceived
and politically unpopular plan. If the purchases of bad debts were at current market prices, there would be no relief. If
they were on more generous terms, then the banks were being bailed out without any obvious benefit to the taxpayer, and irresponsible
lenders were being rewarded. Nor was there any guarantee that the buy-out programme would make more than a marginal impact.
There were, in addition, many practical questions about how the mechanism would work. Congress baulked at the package and,
at the first time of asking, rejected it, fuelling ever more uncertainty. A compromise proposal was then passed, with some
protection for the taxpayer, and the hope was that if toxic debt could be valued – notwithstanding its considerable complexity
– this would create a liquid market for mortgage-backed securities. Once that happened losses could be valued and written
down in an orderly way.

At this key moment, however, the UK government came up with an alternative proposal for injecting money into the banks more
quickly, by advancing capital directly through a form of partial nationalization. The state agreed to invest £37 billion in
leading banks that sought funding to repair their balance sheet in ordinary and preference shares, resulting in the de facto
nationalization of Royal Bank of Scotland / NatWest and HBOS, and a minority stake in Lloyds TSB. The state preference shares
enjoy a 12 per cent interest for taxpayers who receive no dividends on the ordinary shares. Other than the interest rate,
the main attraction for the taxpayer was that the banks agreed to a (rather vague) undertaking to maintain lending and to
restrain bonus payments. The UK package was based on a similar strategy to that which was adopted in Sweden in the early 1990s
to resolve a banking crisis following a property bubble. The Swedish approach was more far-reaching: there was a guarantee
for all deposits and creditors;
and there was a mechanism for separating out bad debts. But it succeeded in stabilizing the banking system, and the government
made money from the subsequent share sell-off.

The British plan for recapitalization was both more direct and more urgent than the Paulson plan and was quickly adopted as
a framework for intervention in the G7 countries. It was also accompanied by measures to guarantee inter-bank lending. The
package, particularly when adopted by other developed countries and accompanied by parallel measures such as a concerted cut
in interest rates, helped to stabilize the position, at least in the short term, though inter-bank lending remained sluggish.

It had become clear by the New Year however that, although the banking system had been saved from immediate collapse, it remained
in desperate straits, requiring continued intervention. In the USA, Bank of America had to be rescued and Citigroup was broken
up. The Irish government nationalized Anglo-Irish. The Commerzbank was rescued in Germany. The British government launched
a scheme to provide guarantees for new business lending and set out the broad framework of a programme to insure the banks’
bad debts. Investors were not impressed; shares fell drastically in RBS/NatWest, Lloyds/HBOS and Barclays in anticipation
of nationalization.

In the event, of the four biggest British banks (each of which was in the top seven in the world in terms of their balance
sheets), Barclays narrowly escaped collapse and nationalization, although it was heavily reliant on very expensive funding
from the Qatari government; HSBC floated clear of the disaster, having been considerably more restrained in its financial
practices than its peers, under the leadership of Stephen Green; Lloyds would have floated clear, but was dragged down by
the disastrous acquisition of HBOS; and RBS, the world’s biggest bank, was effectively taken over. A state shareholding body,
UK Financial Investments Ltd (UKFI), was established to manage the public interest in RBS and Lloyds.

Those interventions stabilized the banks. There has since been no further major collapse in the US, UK or other major economies
(though smaller institutions, such as the Dunfermline Building Society, have failed). The nature of the problem has changed.
Banks, including the semi-nationalized banks, have lurched from recklessness to extreme caution in their lending practices,
hoarding capital (as they have been encouraged to do by the financial regulators). Solvent companies with apparently good
prospects, a goodish profile and decent order books have found their credit lines pulled or their lending conditions tightened,
causing many to fail or lay off staff, thus aggravating the recession. There is still a risk, although it appears to be diminishing,
of deepening recession. This could create more default in corporate debt, on mortgages, credit cards, car loans and commercial
property. This in turn would create more bad debt and more reason for banks to hoard capital rather than lend it. It is easy
to see how such a downward spiral could lead to a deepening slump.

The contraction of credit in some countries has been aggravated by the problems experienced by overseas banks. Several eastern
European countries, such as Hungary, have suffered from the withdrawal of the Austrian banks. Icelandic banks extended themselves
way beyond the capacity of the Icelandic government to provide lender of last resort support and lending banks collapsed,
leading to a withdrawal of credit as well as to losses for depositors in areas where there was a dispute over jurisdiction,
as was the case with deposits in the Isle of Man and the Channel Islands. Irish banks also became overextended in overseas
markets and have since withdrawn. An estimated 30 per cent of UK lending disappeared as a consequence of the problems experienced
by overseas banks. Over the last year, there has been a retreat from cross-border lending generally and the appearance of
what has been called ‘financial protectionism’. It is easy to understand how this problem has arisen. Global banks were not
rescued by the globe but by their own national authorities and taxpayers, who, unsurprisingly, have wanted them to focus on
lending within their own national economies.

There is as yet no clear sign of a reversal of the contraction in lending – which is also what occurred in the ‘great contraction’
from 1929 to 1932. It is precisely because of the institutional memory of that disaster that the pressure has mounted on the
authorities to offset the deflationary risk. Deflation arises because firms slash prices, and wages, in order to survive.
However, consumers, expecting still further price cuts, hold back from spending, thus worsening the outlook for companies
even further and forcing down prices, in a downward spiral. Pre-war experience suggests that it then becomes essential, in
this unusual set of conditions, to provide a monetary stimulus by cutting interest rates, and a fiscal stimulus by, temporarily,
running a larger budget deficit than would normally occur even in a downturn.

Until just recently, all the major developed countries’ central banks have been trying to balance inflationary against deflationary
risk. Their assessment of risk has been heavily influenced by history. The approach of the Federal Reserve is dominated by
lessons learned from the 1930s; that of the European Central Bank by memories of hyperinflation; and that of the UK by recent
experience of inflationary wage–price spirals. The USA, like Europe, had good reason to worry about inflationary risk, since
consumer price index (CPI) inflation had recently passed 5 per cent and inflation expectations, as measured by survey data
and by the gap between real and normal bond yields suggested, until an advanced stage of the crisis, that inflation would
increase.

To set alongside these concerns, however, was the growing worry that a credit squeeze would hit spending and growth; that
a falling housing market would depress the sense of well-being and willingness to spend; and that unemployment would add to
housing market defaults and overall lack of confidence. Deflation was thus becoming a greater risk than inflation, and were
deflation to take hold it would increase the real cost of debt and make the drag of debt on the economy all the more severe.
By November 2008 it was clear to the US and UK authorities – and even to the more reluctant European Central Bank – that interest
rates should
be cut drastically. A year later, leading central banks judged deflationary risk still to be very real, and while there is
talk of an ‘exit strategy’ for easing monetary policy, it is still some way off.

The US authorities in particular, led by Mr Bernanke at the Federal Reserve, have had no inhibitions in taking an aggressive
stance, particularly on monetary policy. There was a deep cut in Federal Reserve Funds interest rates, from 5.25 to 2 per
cent, at the onset of the crisis, almost as radical and more abrupt than the cut from 6.5 to 1 per cent in response to the
perceived threat in the 2000–1 period. The Bush, then Obama, administrations and Congress, between them, contrived a massive
‘Keynesian’ budget deficit – turning a budget surplus of 4 per cent of GDP in 2000, and an expected surplus of 4.5 per cent
in 2005 in the absence of any policy change, into an expected deficit of 14 per cent of GDP in 2009 (that is, Federal government
borrowing). The only developed country with comparable deficit financing is the UK, where, as we saw in the last chapter,
the government has also made the case for ‘reflationary’ policy in order to stave off the expected contraction in demand,
production and employment that could result from financial institutions retreating too rapidly from their function of providing
credit to the real economy. There are those who worry that governments risk creating even bigger problems in the future.

These reservations expose a deep dividing line in policy. In fact, the financial crisis has thrown up two major, related sets
of controversies which expose fundamental fault lines in economic and political thinking. One is how far governments should
intervene to stop panics and financial crises, by acting as lender of last resort, rather than letting them run their course.
The second is whether, in the aftermath of the excesses of the financial crisis, there should be a reversion to tighter regulation
of markets, and, if so, in what form.

The first issue – whether the authorities should intervene in a financial crisis – is one that has preoccupied policy makers
ever
since what Kindleberger calls ‘speculative manias’ have been recorded. These go back to the bubble in tulips, Dutch East India
Company shares and other financial excesses of Holland in the 1630s, or the
Kipper- und Wipperzeit
wave of speculation in coinage among the German princely states a little earlier. From the outset, but particularly with
the emergence of economic theory in eighteenth-century Britain and France, there has been a gulf between those who worried
about moral hazard – the rewarding of imprudence, greed and folly – and those who worried that financial panics would spread
and infect the real economy. The former view was most succinctly summed up by Herbert Spencer: ‘The ultimate result of shielding
man from the effects of folly is to people the world with fools.’ This approach was influential in the years of the Great
Crash, and it helped inform the advice given to President Hoover by his Treasury Secretary, Andrew Mellon: to do nothing.
‘[Panic] will purge the rottenness out of the system… People will work harder and live a more moral life… enterprising people
will pick up the wrecks from less competent people.’ Since Hoover and Mellon emerged as the fools who precipitated the Great
Depression, their abstemiousness became seriously unfashionable.