Yesterday was a disastrous day for the UK. The government had to tell us that its first banking package, amounting to £487 billion of share buying, loans and guarantees, had not done the job. They are now planning another package which includes new loans, new guarantees, the possibility of quantitative easing and an insurance scheme for bad debts.
The timing of this announcement seems to have been related to the publication of the news of the huge losses at RBS. The government had not completed the negotiations with the banks, and had not filled in much of the detail of its proposals, implying it had been rushed by events. We do not know which bad loans or obligations of the banks will be eligible for the insurance scheme, we do not know how they will be valued, we do not know what the insurance premium will be and we do not know the total taxpayer commitment. What we can guess is that the commitment will be large if the policy is to have any beneficial impact, and that pricing the insurance will be very difficult. There is no static and measurable pool of bad and doubtful debts. In this recession the lake of underwater debt is growing at flood rates.
In these circumstances a rumour spread that UK sovereign debt is about to be downgraded by a rating agency, whilst sterling fell again against the dollar and yen. The share prices of RBS and Lloyds plunged, leaving the taxpayer sitting on large unrealised losses on the shares the government has so recently purchased in these two major banks.
People often ask me now, how bad can it get? They have in their voices the apprehension of people who still have their jobs but are worried that all the bad news will one day cross their threshold.. They are relieved that petrol is a bit cheaper and maybe are benefiting from lower mortgages costs, but concerned that things might get tougher for them in some unforeseen way.
The answer is they could get a lot worse. The government has to avoid moving from a very serious problem of weak and overborrowed banks, to an even worse problem of a weak and overborrowed state. We need to be able to keep confidence in our currency and in the government’s capacity to borrow and spend sensibly. Were the government to lose the confidence of the bond markets and were the continuous decline of sterling to become a rout of the currency we would be in for much higher interest rates, much higher unemployment, and a further cut in living standards for many.
The starting point for the government’s analysis should be my simple point that the major banks in the UK are too big for the state to assume all their liabilities, or all their bad debts. The Chancellor yesterday confirmed they were looking at insurance for all the overseas loans as well as the UK ones, and seemed unclear on all the derivative and other financial instrument activities that these banks undertake. Put together, this all amounts to too much risk for taxpayers.
The second perception they need is that the private sector is short of cash. Companies are short of orders and revenue, Many individuals are overborrowed and are having to pay off credit card debts and other loans. They need more money. They are not necessarily going to go out and borrow more, even if the banks suddenly are in a position to lend it. The government does need to work on the money supply to ease the squeeze.
The government does need some combination of the schemes it announced in outline yesterday. It also needs to put some limit on the amount the state will spend and borrow, to start to instil some confidence in its own finances again. It should be seeking to dig its way out of its expensive and so far disastrous share buying amongst the banks, and finding cheaper ways of seeing the banks through a painful period of adjustment. Short term loans against security, the provision of banking cash and maybe guarantees on inter bank and new lending are the least bad ways of doing this. The banks themselves have to cut costs, change their business models and reduce their risks. Subsidising them too much delays this necessary process. Buying their shares just puts the taxpayer in line to pay the losses, which as we saw yesterday are eye wateringly large. When I first said the three banks the government was buying shares in could lose the equivalent of the defence budget, many people looked surprised. That is what RBS has announced on its own just a few weeks after the government bought shares!