Friday, 5 August 2011

Black Thursday

As I write, it is four in the morning and I am watching the Asian stock markets falling. Yesterday both the FTSE100 and the Dow Jones crashed, and further falls are expected today. No-one seems to have any real idea why stock markets are collapsing around the world. But on one thing everyone is agreed - we have a worldwide financial crisis. Global Financial Crisis Two (GFC2) has landed.

The seeds of this crisis were sown in the Global Financial Crisis of 2008 (GFC1). In fact you could say that that crisis never really ended, it just calmed down for a while. We have been in the eye of the storm, but now the winds are lashing us again.

The reason why it has all blown up again is very clear. We didn't actually fix the problems that caused the 2008 GFC. All we did was move the problems to countries instead. Which makes things worse.

In 2008 many major banks, and one huge insurance company, failed due to assets turning out to be worthless, and massive uninsured liabilities. Other banks failed because interbank markets froze and there was, at the time, no other major source of cheap funds.  Our solution to these problems was to take the debts of these banks on to national balance sheets, and to provide more low-risk liquid assets to markets to prevent them freezing again. This was the biggest transfer of private debt to the public sector in history. Now let's be clear about what this really means: it was the transfer of INSTITUTIONAL DEBT to INDIVIDUALS.  It was not governments that bailed out the banks. It was taxpayers.

The result is that many countries that bailed out their banks are heavily indebted - yes, obviously there are assets (shares) offsetting those debts, but those are unrealised and after yesterday worth a lot less than a few days ago. Furthermore, the collapse of the banking system sparked a deep recession during which national debts around the world rose enormously as tax receipts fell and benefit payments increased. Now, it is normal for public debt to increase in a recession, and this should sort itself out once the economy starts to grow again. But our economies haven't grown, and the debt levels in many countries have become unaffordable. The result is that we now have a sovereign debt crisis. Whereas in GFC1 the failing institutions were banks, in GFC2 they are countries.

This is appalling. When a major bank fails, depositors lose money, borrowers may have loans foreclosed, and if the bank is a clearer essential payments may not be made. That's bad enough, and it is easy to see why governments believed that these problems were serious enough to warrant using taxpayers' money to prevent banks failing.  But what we now have is a thousand times worse. Bankruptcy for a country means years and years of poverty; it may mean forced asset sales, massive unemployment levels, demolition of welfare and withdrawal of benefits. It may even mean that salaries aren't paid, sometimes for years, that power and transport systems fail, and that food becomes unobtainable or unaffordable. We have seen all of these happen in various countries in the last few years, notably in sub-saharan Africa, in Latin America and in Eastern Europe. But nobody ever thought this could happen in the rich Western World.

Well, it is happening, right now. And we don't know what to do about it. The recent US debt ceiling farce arose because there is no political agreement on the best course of action to manage the US's humungous debt. The EU has come up with one scheme after another to provide funds to Greece to enable it to pay its debts, all of which have foundered on a rock called "default". Meanwhile other EU nations are also experiencing debt distress, which the EU so far has simply refused to acknowledge. The UK is standing on the sidelines looking virtuous while slipping further and further into economic decline. No-one is fooled.

There is a leadership vacuum in the Western world. Since the US debt ceiling debacle and the abject failure of all the EU's silly schemes for bailing out German and French banks Greece, not one political leader now has the credibility to take the lead and decide what to do.  Lagarde, the new IMF head, looked promising - for about five minutes: then she was tarnished by a possible corruption scandal and that was the end of her as a credible political leader for this ghastly mess.

So is it really so surprising that markets are collapsing? We have an unstable, highly indebted financial system, unstable, highly indebted corporations, and unstable, highly indebted countries. And we have no-one capable, it seems, of sorting it out.

It seems to me that we have ignored some very fundamental principles in our handling of the GFCs. The first one, for me, is that IT IS NECESSARY FOR FAILING INSTITUTIONS TO FAIL. It may seem less painful to prop them up, bail them out, throw money at them, change their management teams, load them with heaps of regulation, even break them up into smaller bits. But we've seen all this before, notably with the big nationalised industries of the 1970s. All the support they received from the taxpayer wasn't enough to stop their eventual closure. It just cost lots more and hurt lots more people.  Isn't that exactly what we are doing with our zombie banks - keeping them going at taxpayers' expense? For how long can we realistically maintain the illusion of a healthy, well-functioning banking system? It isn't anything of the kind. Without taxpayer support it would collapse. Please, let it fail. Then maybe from its ashes a new financial system will arise, which would genuinely operate as the public service it should be.

The second principle in handling the GFCs is this: PEOPLE NEED TO BE PROTECTED FROM THE CONSEQUENCES OF INSTITUTIONAL FAILURE.  And here's where we went wrong in GFC1. We confused protecting people with propping up failing institutions. Yes, if a major clearing bank fails, depositors need to be protected from losses, borrowers need to be protected from sudden foreclosure, and emergency measures are needed to ensure that essential payments can be made. But that doesn't mean the INSTITUTION should be bailed out. It should be allowed to fail.

Had the indebted banks from GFC1 been allowed to fail, the US and UK public debt levels would not be the size they are (and we wouldn't be losing shedloads on share value writedowns).  The only major expense arising from supporting people is depositor cover, and much of that was already covered by insurance anyway. Emergency arrangements could have been made with other banks to cover payments, and lending portfolios could have been resold by administrators - including, in my view, toxic assets. There's always a market, even for risky debt.

But what about Europe? The debt levels in the European periphery don't come from bank bailouts, except in the case of Ireland, which absolutely shouldn't have bailed out its banks and I for one am appalled that it did. They come from overspending. 

Well, that's true. But it is still about bank bailouts, really. None of the money that has been lent to Greece by the ECB has gone to supporting people so that they can rebuild their lives and revitalise the Greek economy. Had it done so, in the short term banks (mainly French and German ones) would take a loss, but in the longer term Greece would be able to pay them off because economic growth would give it the means to do so. But instead, the money that has been lent to Greece has gone to pay French and German banks. In other words, German and French taxpayers have bailed out their banks - again. Greece was just an intermediary, though it was asset-stripped in the process mainly so that German taxpayers didn't realise they were being scammed. Were they fooled? Maybe. But we're about to repeat the same mistakes with Portugal, Spain, Italy - and that's where the German taxpayers (I hope) dig their heels in and shout "NEIN!". No way should taxpayers be on the hook for the consequences of stupid lending by their banks. Peripheral Eurozone countries aren't going to pay their debts. Those banks' assets are toxic. Let them fail.

The way we handled GFC1 was a big disaster, and because of that we now have an even bigger disaster. Will we get this one right? It's not looking good at the moment.

13 comments:

  1. What an excellent blog post. I think your analysis is spot-on. The problem is the politico/banker cabal are desperately trying to protect their very narrow interests, we're being taxed till we bleed to pay for them, and there's no sane voice or leaders.

    Revolution anybody?

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  2. Thank you Frances for an informative article, one using plain English - much appreciated by a financial dumbo such as I

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  3. Excellent post Frances. Really good

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  4. Thanks for such a clear explanation. Presumably, at some point, taxpayers will run out of money and credit, then what? Or do we keep borrowing until, until...

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  5. I second the comments by Witterings.... and Mike Parker above. Thank you.

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  6. Frances, I think you should be put in charge of sorting this out.

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  7. Excellent piece.

    Not sure how it would work, but isn't the *debt* these institutions own the problem in the first place? When it's sold on, isn't there a danger they'll bundle the bad debt in with the good and that'll just keep the problem in the market?

    I'm half of a mind that the deposits/debts should just be dissolved when the institution fails. Painful for some, useful for others (No more savings! No more mortgage!), but that would just cause a mass run on the other banks (some of which might be healthy).

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  8. Yeah money in banks isnt safe. Given the deflationary pressures cash is looking good. Run on the banks anyone?

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  9. So if you know all this, why don't governments know all this and do the right thing? I don't want my children to starve!

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  10. Great post - a couple of small points:

    'The debt levels in the European periphery don't come from bank bailouts, except in the case of Ireland, which absolutely shouldn't have bailed out its banks and I for one am appalled that it did. They come from overspending.'

    Spain were also running a surplus, and Greece didn't come from 'overspending' it came from undertaxation, avoidance etc. The only countries you can accuse of profligacy are Italy and possibly Portugal, although they too had a big housing crash.

    I know you weren't really accusing them of profligacy but I enjoy being pedantic.

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  13. Excellent article above. May be you need more time to share all the knowledge that you have.
    So, thanks for share this information with us, I always come across this amazing post.

    ReplyDelete