From Wall Street to Main Street, from the City to the High Street

We are now entering the second phase of the Credit Crunch, the time when the crisis has a direct impact on the rest of the economy. The first phase was a problem for the bankers and brokers. The second phase is a problem for all of us.

In the early days of the Crunch there was some pleasure by many in the US and the UK to see rich financiers losing their jobs, or finding their share options and bonuses wiped out. The years of plenty and easy money for bankers had produced plenty of jealousy and anger outside their privileged banking halls. The feeling that the bankers should be made to pay was still there when the Bush administration came up with its $700 billion package to buy distressed debt from the banks. People asked “Why should Wall Street be bailed out?”. Wouldn’t this nationalise the losses, after the bankers had pocketed the profits?

The political establishment who wants to “bail out” the banks argues correctly that crisis on Wall Street will also hit Main Street. They try to persuade their electors that they must spend all this money, otherwise the banks will be unable to lend sufficient to American borrowers to run their businesses, buy their homes and carry out their normal transactions. The public seeks guarantees that any bail out will not leach public money into shareholders dividends or bankers pay.

The revised version of the Bill to be voted on shortly attempts to deal with these very reasonable concerns. It offers the US taxpayer a stake in banks that sell their loans to the government. It provides for controls over executive pay. It implies a new level of state control over US banking we have not seen before, on the very reasonable argument that the taxpayer is having to pay so much so the taxpayer deserves a say and a stake in the future business of any participating bank. The danger is that the terms may become unattractive to banks, and knowledge that a bank has to participate in the scheme may not be as good for confidence as the Administration hopes. There are no easy answers.

The argument is sometimes presented in stark terms as a struggle between a benign establishment – both Democrat and Republican – who want to save the banking system and therefore the economy, and a group of backwoodsmen and women who are “playing politics” in a way which will endanger the system. It is a pity it is so presented. What we need is a debate about what kind of a package will have most chance of success, rather than a debate about whether there is any need for action.

There can be no doubt that the banking system is in trouble. Given the run of news on both sides of the Atlantic you would need to have avoided all media programmes and newspapers for a year not to understand that. There can be no doubt that weak banks unable to lend much will undermine the general economy. US and UK voters are beginning to accept that. The issue should be, what combination of actions by the banks, the rest of the private sector, the Central Banks and governments can get the banking markets working again sufficiently to avoid deep recession? That may include some spending of public money, but it may revolve rather more around the spending of private money to recapitalise the banks and around actions by the Regulators to move their rules into a shape which help fight deflation rather than inflation.

The sad truth is that even if you did want the taxpayer to take on the banking black hole and fill it with taxpayers money, it is too big to do that comfortably. Governments have been part of the problem. They have borrowed too much, and certainly in the UK have themselves used the modern off balance sheet techniques of finance which they are now criticising others for doing. Both the US and the UK governments have to accept there are limits to how much money they can borrow and commit to sorting out banks, otherwise the credit worthiness of government will become the issue. Governments must keep people believing in their financial management, so government guarantees when offered are things of value and mean something. Governments also need to understand that the capital needs of the banks are very large.

The banking crisis will only be resolved when banks believe each other major bank has adequate capital, and a sensibly structured balance sheet. Total debt will be reduced and has to be reduced. If it is done too quickly the consequences for the rest of the economy will be severe. Banking capital has to be increased. That means banks have to sell a lot more shares to raise new money, at low prices. That will adversely affect existing shareholders, but there is no alternative to taking such action. The sooner the banks get on with an other round of fund raising the better.

Expect over the weeks ahead to see banks trying to cut their loan portfolios to get their balance sheets into better shape. They will exert pressure on companies to reduce their overdrafts and repay their term loans, or face increases in rates and charges where these can be raised. They will lend people a lower proportion of a reduced house value if offering mortgages at all. They will be tougher over consumer loans. As a result there will be fewer houses and cars sold, fewer purchases of discretionary items in the shops, and lower prices for many items. Manufacturers will cut their output and lay off staff. Some retailers will sack people and be forced to reduce the scale of their operations. Restaurants, bars and hotels will face falling trade. At the very time when more people and businesses will want to borrow to tide them over a fall in income the banks will say they cannot borrow more. Government borrowing will surge as government will be left paying the extra benefits and collecting the lower tax revenue brought about by the slowdown.

Some of my critics on this website think I am underestimating the inflation problem. I know pensioners are understandably afraid of this winter’s fuel bills. Many people live in dread of the ever rising Council Tax bill. A trip to the supermarket is a shock to the prudent and those on lower incomes. Fear does stalk the land. People’s most recent experience is of rapidly rising prices. Savers are afraid that their savings income will fall, when it is already inadequate to meet the bills. All this is true, and reflects past mistakes which cannot now be corrected.

Today the authorities in the UK are making a different mistake. They are taking too many risks with deflation. Whilst the fall in some prices to come will be welcome, the rise in unemployment, collapse of asset prices and the difficulty in keeping businesses going will leave no household in the land untouched. To those who think the fires of recession are purgative I say remember many will be badly burned by them first if they are fanned by the authorities.

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6 Comments

  1. Johnny Norfolk
    Posted October 3, 2008 at 7:31 am | Permalink

    Sad but so very true. The true price of a Labour government.

  2. Tony Makara
    Posted October 3, 2008 at 8:06 am | Permalink

    On inflation, it is very important that we understand that there are different versions of inflation from cost-push inflationary pressures, to when the amount of new money entering circulation outpaces, that is over-represents, the amount of new goods and services created, this is especially important when nations are no longer creating goods and services but are living off imports, the cost of interest being written into the final price of goods and services and in contrast lower interest rates weakening the currency and creating import-inflation. The inflation problem cannot be addressed by one single policy and needs to be understood by looking at all economic factors.

    On banking, it has always struck me as curious as to why national governments resort to borrowing through gilt-edged securities, when the state itself could establish a national bank and actually support the economy by way of of interest-free loans to business by creating an issue of money, then later recalling and destroying the loan once it has circulated and has created goods and services? Government could create new money at will and recall and destroy that particular issue of money at will. National governments have become too reliant on the money markets and now need to be looking at alternatives rather than propping up a broken lending system with bail-outs and the nationalization of failed lenders. A national bank would provide the level of security needed and would be a fillip to business by providing transient interest-free issues of money, in the shape of loans.

    • StevenL
      Posted October 3, 2008 at 5:14 pm | Permalink

      There's probably far too many vested interests involved for this to become reality. We could eradicate overnight half the crime in this country if we legalised and regulated narcotics. The yanks would never let us though.

  3. Adrian Peirson
    Posted October 3, 2008 at 1:27 pm | Permalink

    I think we should let them fail, pass a law giving people full ownership of their cars, buisnesses and homes, IE wipe out all loans to the banks in question and let them fail.
    People will have more money, they will spend, this will feed the need for the remaining and new banks to fill the void.
    In physics infinities can be dealth with by a cheat' called renormalisation.
    And since our money is no longer backed by anything of value like gold or silver, since credit is thin air, and the central idea behind fractional reserve banking is that they are lending out assets that they do not actually have.
    It seems the Perfect opportunity to renormalise the system and at the same time begin operating a system based on sound money, not outright fraud as it is now.

  4. Robert
    Posted October 3, 2008 at 4:31 pm | Permalink

    John, all of what you say makes very good sense as I would expect and I agree with most of what you say, but the politician in you seems to deny the empirical fact that corrections in asset prices have to happen to reconnect to sensible fundementals. We can't escape the sad reality that we will all suffer, with some particularly hard hit by being overgeared and having lived the debt/asset fuelled lifestyle over the last few years, and there will be many most sadly that will lose their jobs. Much earlier action at least 3 to 5 years ago might have minimised our potential downside. But we are where we are, and as you say we will have another round of fund raising by the Banks and a much reduced access to capital as Banks rebuild their balance sheets over the next 2-3 years. The fact that the wholesale market grew from 0 in 2000 to 750bn in 2007 (BBC News last night), not withstanding the leverage with which this was used says an aweful lot. Also the banks may have to w/d and make serious provisions on their corporate/consumer loan side – loan loss provisions rose to 3.5-4% during the early nineties and most likely will have to again (it could be even worse), yet another hit that they will have to take. Yes, the MPC should start to cut this Autumn. But as I have said on occassions it won't be the palliative that it is has been before, as until the lending market starts to return to more 'normalised' conditions the real 'benefit' of cheaper money won't be passed on fully to either corporates or consumers. But it has to be the right thing to do, though yet again 'sound'

    money/capital is not being priced correctly.

    Reply: Yes there do have to be asset adjustments, but a complete collapse will lead to far worse in the real economy and hit many people who were prudent.

    • Robert
      Posted October 4, 2008 at 10:59 pm | Permalink

      John,
      As an academic exercise last year I workd out that asset prices have to fall circa 50% so that first time buyers (using regional average incomes) on 3x multiples and a 15% deposit could then buy a typical dwelling (small terraced house in most urban locations/villages or a 1-2 bedroom flat in the 'flashier' locations). I know this was a very rough 'exercise', and assumes that the money will be available, but at least here sensible risk/reward fundementals would potentially kick in. As I posted before, you either have affordability go up implying huge wage inflation or massively increase the supply side! The third way is but a dream that most pundits were clinging to in '06 and '07 to defend taht house prices would not need to correct. For those of us that have de-leveraged, as you have suggested earlier, it is not easier either, where is your money safe? This situation is that the 'establishment', be it the government and many, not all, city institutions hadcompletely lost the plot for years. Markets in illiquid assets never move in a reasonable, particularly now we have a full blown banking crisis. I do pray that it is not as bad as I think it will be. I cling to the hope that the actions carried out to date will start to stabilise the situation but I remember markets recovered post the big crash but then fell away. I just hope we keep global trade going if there is the finance to support.

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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