First published in the Telegraph on 5 October 2008
Here they come – the credit crunch cavalry; here to sweep us away from all this economic misery. In they waft from the five-star hotels and embassies of Washington, carried aloft on a ribbon of dry ice and dollar bills. The crowd swoons with excitement as the silhouettes of Hank Paulson, Alistair Darling and the rest of the Fantastic Seven heave into sight.
If the image is ridiculous, it is perhaps not so far from reality as it once was. This week the Group of Seven (G7) leading finance ministers descend on the capital of the free world. The air is already swimming with fevered speculation about a new world financial deal: a Bretton Woods for the 21st century; a blueprint for tomorrow’s financial system; an inspirational plan for an international financial regulator to ensure that nothing like this happens again.
Such excitement is to be expected. It is also misplaced, although this hardly matters – the week that has just passed was a turning point, perhaps the most important since the financial turmoil began.
They may not be superheroes, but last week finance ministers finally faced up foursquare to the credit crisis. There were the now obligatory bank collapses, panicked traders, record slumps in equity prices and sweating central banks, but far more important was that the biggest, longest-lived and most dangerous misconception of all died: that governments could get through this without forking out billions of taxpayer bucks to rescue the financial system.
It is a terrible prospect, whatever your political stance. After Friday’s Congressional vote, the United States has, in one fell swoop, increased its national debt by about the same amount the Iraq war has cost. Almost all rich countries will have to borrow massively to get out of this hole. As a result, there will be less money to spend in the coming years. All those bold proposals by Obama and McCain may have to be rethought – the US has just smashed open the piggy bank it was saving for the next decade.
Horrifying as it all is, it beats the alternative: a rerun of the 1930s. We have only just realised on both sides of the Atlantic how close we have come to the edge. The atmosphere has been febrile enough since last August, but not until the past few days did banks face a widespread run, as everyone from savers to hedge funds to companies to pension funds pulled their money out of the system.
What was new was not just the virulence of the infection but the way it struck the US and Europe at the same time. The lie that this was specifically an American or even an Anglo-Saxon problem has been laid to rest – in fact, it turns out that the banks in Germany and France were the biggest buyers of US sub-prime mortgage securities, the financial weapons of mass destruction at the heart of the crisis.
Since the start of this turmoil, politicians have been able to advance an easy excuse for the absence of decisive, comprehensive action: there was no obvious solution, since it was not clear what was happening. Now that excuse no longer washes.
The problem is quite simple: vast swathes of the banking system are close to insolvency. Following the collapse of major parts of banks’ life-support system – the securitisation and money markets – they fell victim to a double run as first shareholders and then depositors abandoned them.
For all its sound and fury, the Paulson plan only goes some of the way towards resolving this. By providing banks with a toxic dump for their nastiest securities, the US taxpayers’ $700 billion ( pounds 400 bn) helps cleanse the system. But it will not prevent more banks from collapsing. More money will probably have to be injected. Ken Rogoff, professor of economics at Harvard, reckons the eventual cost could hit an eye-watering $2 trillion ( pounds 1,100 bn).
The rule in this situation is simple. The sooner you fork out the cash, the less the eventual cost will be. To see why, you only have to look back to the early 1990s, when the world suffered two banking crises: one in Scandinavia, the other in Japan.
The circumstances were much the same as those we face now, a debt-fuelled binge followed by a slump in housing and equity prices and a decimated banking industry. The Nordic crisis was short-lived, but Japan suffered a Lost Decade of stagnation, deflation and falling house prices.
What was the difference? The Scandinavian governments acted decisively, slashing interest rates and bailing out the banking system. Japanese policymakers, on the other hand, took too long to face up to their problems. They cut rates too slowly and, reluctant to pump taxpayers’ funds into the banking industry, kept banks on life support without giving them the surgery they needed.
It now looks very much as if Paulson is heading down the Nordic route. So too are a number of European countries, although judging by the emergency summit called by President Sarkozy in Paris yesterday, they still haven’t made up their mind whether to launch a co-ordinated rescue plan or tackle the crisis state by state. Most likely they will fall on the latter. It is difficult enough to justify spending public money on a domestic bail-out, let alone one for another country.
Which brings us to the UK. As eyes sweep round the table in Washington this week, they will undoubtedly pause when they reach Alistair Darling. He and Gordon Brown have stuck out like a sore thumb for their relative inaction. Before last week this might have been applauded as sure-footedness, but not now.
The British economy is arguably among the most vulnerable of all, and yet its policymakers have done less than almost all their peers to try to mitigate the disaster. Already the effects of the credit crunch are apparent. House prices and mortgage lending have slumped more dramatically than in recorded history; unemployment has started to rise; the economy is almost certainly slipping into recession.
Most worrying of all, this has happened before the impact of the past few weeks has fed into the system.
Almost every measure implemented by Brown has been more sticking plaster than surgery. His proposal yesterday for a pounds 12 billion pan-European fund for struggling small businesses is a typical example. It is neither big enough to make a significant difference for businesses, nor will it do anything to solve the banking crisis. He promised “global solutions” for the turmoil but, as the Paulson plan shows, sometimes countries have to act
The longer he holds off radical reforms, which means throwing a significant chunk of money ( pounds 50 billion, perhaps more) at failing banks, the worse our prospects are for the coming years. It is shocking that, given David Cameron is likely to inherit this mess, neither he nor George Osborne has lobbied the Government publicly to do more.
The Bank of England is likely to cut interest rates this week – perhaps even by a half percentage point. However, lower borrowing costs are not enough. Unless something radical is done soon, Britain faces its own Lost Decade of high unemployment, stagnation and possible deflation.
Worst of all, it is an eventuality that is avoidable. But only if the Government grasps the nettle, and does it soon.