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.