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Now we're getting somewhere

October 12th, 2008

The British government has abandoned proposals for non-voting preference shares and is moving towards full-scale nationalisation of the banking sector. According to the London Times(h/t Felix Salmon) the latest proposals would leave the government owning 70 per cent of Royal Bank of Scotland and 50 per cent of Halifax. The London stockmarket is likely to be closed, and it seems unlikely that many banks will remain private by the time it reopens. Presumably, with Morgan Stanley and Goldman Sachs in deep strife, the US can’t be far behind, though Paulson is still talking nonsense about non-voting shares. Still, it’s only three weeks ago that he was opposing any kind of public equity, and only six weeks ago that he was claiming that there were no real problems.

As the Times says, no-one knows how much toxic sludge will turn up when the government finally gets access to the books, but it seems unlikely that most governments will be overwhelmed in the way that Iceland has been. The capacity of developed-country governments to raise additional revenue is huge, easily enough to cover trillions in bad debt over a few years. So, once the sector is nationalised it should be possible to get lending flowing again. And, the prospects for an orderly shutdown of the massively overgrown markets for derivatives like credit default swaps suddenly seem a lot better.

It’s fascinating to wonder how Gordon Brown and Alistair Darling must feel about all this. Having long abandoned their youthful leftism, they have suddenly been forced by circumstances to implement something that looks superficially like socialism, and might even lead to a genuine restructuring of society (utopian I know, but who would have thought a month ago that we would have been wondering what to do with a nationalised finance sector). At the very least, Brown and Darling must have found it easier to adapt to the sudden collapse of the existing order than those who have never imagined anything else.

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  1. chris joye
    October 12th, 2008 at 21:21 | #1

    For the vast bulk of these institutions, the problem is not the underlying assets. I would venture that there is, in fact, relatively little ‘toxic sludge’. Most of these banks lent very prudently. The real issue is much more fundamental. What we are seeing are the intrinsic shortcomings associated with the functioning of the market mechanism, which has been severely exacerbated by the advent mark-to-market accounting (predicated, as it is, on efficient market pricing), and the emergence of borderless capital markets enabled by technological innovations such as the Internet and 24/7 electronic trading that overcome the investor “proximity preference� of days gone by (ie, where capital was geographically anchored). Many of the market inefficiencies that tended to be confined to individual countries have now been unleashed and amplified on a global basis via network effects. We saw the first dawn of this with the 1987 stock market crash, which was followed by the 1997 Asian crisis, the 1998 LTCM bail-out, the late 1990s tech boom and early 2000s tech wreck, and now the great credit boom and bust. And so the seemingly insignificant butterfly that was the non-conforming US households who failed to meet their mortgage repayments has precipitated cataclysmic and entirely unforeseeable consequences across the world from the death of non-bank lending in Australia to the nationalisation of the UK banking system. I think that what we are learning is that financial markets are inherently unstable and render the concept of economic equilibrium utterly obsolete.

  2. SJ
    October 12th, 2008 at 21:33 | #2

    chris, is there anything that you’ve said that can’t be alternatively explained as “excessive leverage”?

  3. October 12th, 2008 at 22:26 | #3

    John, I don’t think you want governments directing the allocation of private investment funds. For this reason the non-voting shares option seems to have sense. It provides liquidity to banks by bolstering their shareholder funds but does not deliver what is effectively a communist society where government has the power to control every lending and every commercial decision.

    If the government does buy substantial voting shareholdings these should be sold down ASAP.

    You can also imagine the stance of pollies like Rudd if the banks tried to cut staff to reduce costs. John, would you really want bureaucrats like Kevin Rudd controlling the overall direction of lending decisions? How much would be invested in more daft water schemes, green cars and social engineering?

    One can see the silliness evident in the cries to limit executive salaries in order to resolve the banking crisis. Groups such as the ALP (and John McCain) thrive on this populist nonsense.

    The current situation is a disaster no question and deserves analysis once the scale of the catastrophe becomes evident. For the moment bthe vissue is to restore trust in credit markets. The disaster will cost jobs – and seriously given what Malcolm Turnbull said today – delays in dealing with such things as climate change.

    Suggestions that the crisis should be used to switch toward ‘utopian socialism’ where politicians drive 100% of the economic agenda should not be entertained.

    Gary Becker has some good thoughts on this:

    http://www.becker-posner-blog.com/archives/2008/10/government_equi.html.

    To SJ, Banks are always heavily leveraged – the nature of their business. They made too many correlated bad loans.

  4. rog
    October 12th, 2008 at 22:33 | #4

    Suspending the UK stock exchange should just about stuff all the others…thanks again

  5. sean
    October 12th, 2008 at 22:55 | #5

    The crap gets crappier!

    The only solution that stands any chance of working is recapitalisation using the debt for equity.

    The current solution is a political one, they are acting in their own interests (voters wealth) by delaying the inevitable and trying to support asset prices.

    Alice Cook

    Prof Willem Buiter

  6. sean
    October 12th, 2008 at 23:46 | #6

    “So, once the sector is nationalised it should be possible to get lending flowing again. ”

    Is that exactly the problem that got us into this mess in the first place?

    I think folks paying off their loans is what will ease the credit markets, as well as a massive cull on the bloated financial services industry.

    btw, inter bank lending is not at a standstill its just expensive, its called supply and demand the last time I looked.

  7. Damocles
    October 13th, 2008 at 00:00 | #7

    http://www.bloomberg.com/apps/news?pid=20601102&sid=aVla_.YxlbVs&refer=uk

    Before people spend too much time and energy on the details of the Times story, it’s worth noting that other sources,such as the Guardian and Bloomberg, are suggesting the Brits have something more modest in mind – if $35 billion pounds in public equity for the banking sector can be described as modest.

    As a general observation, I doubt that any equity stakes in banks in Britain or elsewhere will result in the nationalization of the sector in the old-fashioned sense of the word.

    What’s more likely is some equivalent of the Hong Kong Tracker Fund to hold the equity stakes and dispose of them as the markets recover.

  8. observa
    October 13th, 2008 at 00:14 | #8

    Gee whiz, the prospect of turning all the greedy banks into Govt run Freddies and Fannies for more ‘social’ lending and if the inter Freddie and Fannie lending ever gets ‘too dear’ then they can simply lower the interest rates sean. Overlay public service pay scales and job security on current bank staff and that’s the whole box and dice wrapped up neatly.

  9. observa
    October 13th, 2008 at 00:29 | #9

    Makes you wonder why someone hasn’t thought of it before, so perhaps there’s just one piece of the puzzle missing like nationalising private gold holdings.

  10. rog
    October 13th, 2008 at 05:59 | #10

    Leaders are busy denying their previous statements of closing global markets, the White House says they have no plans to interfere with markets.

    So what is the Fed and what was the bailout?

  11. Spiros
    October 13th, 2008 at 07:14 | #11

    “How much would be invested in more daft water schemes, green cars and social engineering?”

    In contrast to sensible investments like CDOs, CDOs squareds etc, right Harry?

    Iceland had a boring and sensible government owned banking system until a few years ago. The Icelandic banks were privatised and got all private sector entrepreneurial. Now it doesn’t have a banking system at all.

  12. Damocles
    October 13th, 2008 at 08:13 | #12

    “Makes you wonder why someone hasn’t thought of it before, so perhaps there’s just one piece of the puzzle missing like nationalising private gold holdings.”

    About the one thing that would cause that would be if you got your wish and the world adopted the gold standard.

    There’d be an immediate gigantic need for gold for official reserves. There’d probably also be curbs on gold trading to prevent wild swings in currency values as the system was established.

    The first thing the Australian government would do would probably be to take over the WA Gold Corporation and issue the bearers of its gold certificates ten year government bonds in their place.

  13. Chris Lloyd
    October 13th, 2008 at 08:15 | #13

    HC said: “They made too many correlated bad loans.” Well that’s OK then. Just a slight technical hitch and nothing wrong with the system at all.

  14. Ernestine Gross
    October 13th, 2008 at 08:35 | #14

    Re 1: “I think that what we are learning is that financial markets are inherently unstable and render the concept of economic equilibrium utterly obsolete.”

    I agree with the first part of the sentence but I don’t understand the second.

    To the best of my knowledge there isn’t one unique concept of “economic equilibrum”. The definition of ‘an equilibrium’ depends on the specific theoretical model. Further, the theoretical existence (in the logic of mathematics) of ‘an equilibrium’ in a specified theoretical model depends on specifed conditions (which are amenable to empirical exmination).

  15. October 13th, 2008 at 08:38 | #15

    Spiros, Of course I am not defending those financial instruments. This does not imply a case for nationalising banks and the disasterous Icelandic experience doesn’t either.

    Chris, Correlation is more than a technical hitch. If banks are lending to millions of borrowers and real estate prices are correlated then in a slump the banks will experience difficulties. I wasn’t attempting to minimise the significance of this possibility.

  16. Hal9000
    October 13th, 2008 at 08:44 | #16

    “I don’t think you want governments directing the allocation of private investment funds. For this reason the non-voting shares option seems to have sense.”

    And there was I thinking it was a basic principle of the market economy that when you buy something, you own it. Somehow this new non-ownership model you’re advancing here hc looks to be more communist than the state-ownership ‘problem’ you’re seeking to solve.

  17. ehj2
    October 13th, 2008 at 08:52 | #17

    I would nationalize deposit banks and make them “near” banks of the central banks.

    I would regulate deposit banks so that they can’t fail, guarantee bank deposits, and have a firewall between deposit banks and investment houses and the casino of wall street.

    Then I would place a federal version of a ratings agency (a Moody’s) in the firewall, so that during these inevitable collapses, securities from wall street can be regraded (downgraded) before being turned into “guaranteed” deposits in a deposit bank.

    As an engineer, I know if I put water in a pipe or push electrons into a wire, these substances really are “somewhere” and I can guarantee them.

    If economists really can’t design a banking system that knows where money is and can guarantee it to be there, then they really don’t understand what money is and should stop being so adamant about how “sound” it is and market fundamentals.

    Since we’re building the firewall now to regrade all these junk securities, we should just keep it in place to protect our newly nationalized deposit banks from dollars we won’t back.

    Then we’ll never again have to worry about inter-bank lending, and we really can allow the markets “out there” to fail.

  18. Socrates
    October 13th, 2008 at 08:54 | #18

    Talk of limiting executive salaries is not populist nonsense. It is a broken market and controls are needed. Evidence shows that directors and remuneration committees are not setting sufficient performance hurdles for execs to jump, and the idea that the execs cause the outcome is flawed. See Bebchuck & Grinstein’s analysis which shows that by early 2000s executive pay (top 5 execs only) equalled 10% of profits for top 1200 US corps! Australia isn’t much better, with Shields showing tehat the correlation between CEO pay and performance here is negative.

  19. derrida derider
    October 13th, 2008 at 09:31 | #19

    I’d like to pick up on Harry’s point about likely delays in dealing with climate change because of the recession. This seems dead wrong to me:

    - the capital investments needed to create more alternative energy sources and more energy efficient transport are exactly what is needed at the moment.

    - to the extent that the ETS reduces labour productivity, this is a Good Thing in the short run where there is likely to be an excess supply of labour. The bottom of a recession is the one circumstance where the lump of labour fallacy is not entirely a fallacy.

    - the slower rate of economic activity will make it much easier to achieve carbon targets.

    I can’t help thinking that this particular meme being put about is just more special pleading by the old greenhouse mafia.

  20. tin tin
    October 13th, 2008 at 12:40 | #20

    re #20. Climate change is dead. It was killed by the financial crises.

    http://johnquiggin.com/index.php/archives/2008/09/29/monday-message-board-110/#comment-218307

  21. smiths
    October 13th, 2008 at 12:52 | #21

    none of it will solve anything until tax havens,
    shadow regulation and the shadow banking system are sorted out

  22. Socrates
    October 13th, 2008 at 12:56 | #22

    I may not be bad enough at maths to be an investment banker, but regarding climate change, I really fail to see how an economic slowdown (i.e. maybe slight negative in activity of a few %) negates the need to act when the world’s carbon emissions exceed the capacity of natural systems to absorb it by over 50%??? Shares dropping in price does not reduce the emissions from our power plants, cars or farms. If shares went up by 10% would you say emissiosn did the same?

    There is still a huge need to act on climate change, and to say otherwise is quite misleading.

    On the plus side, some investments in alternative energy and rail transport will both stimulate economic activity and reduce emissions. Meanwhile the drop in construction activity will free up resources to deploy in this area. Its a good time to act!

  23. observa
    October 13th, 2008 at 16:03 | #23

    “In light of the significant events in world financial markets over the last week and the federal government’s constructive initiatives for the financial sector announced yesterday, Suncorp is assessing the implications for the potential sale of its banking and wealth management operation,” the Brisbane-based company said in a statement today.

    Yes I’ll bet they are and naturally with Kev’s banking business guarantee on our behalf our dollar clicked up a cent while the Big 4 banks’ share prices have clicked up between 7-13% today. That may well attract OS hot money back here to continue a bit more business as usual if we add in Kev’s $4bill for the poor Aussies to helpya! Stagflate our way out of the mess by the looks of things, but that may well prove a bit more problematic this time round. If Kev aint gunna buy gold with our funny money then I reckon this was the next best option for it-
    http://www.ausubel.com/auction-papers/ausubel-cramton-auctions-for-injecting-bank-capital.pdf

  24. observa
    October 13th, 2008 at 16:13 | #24

    Don’t you just love that phrase ‘constructive initiatives’ in light of certain significant events? Bloody priceless aren’t they!

  25. Michael of Summer Hill
    October 13th, 2008 at 16:17 | #25

    John, partial nationalisation of the banking sector may be the future norm but governments should focus more on pump priming the economy in order to avoid any recession and an economic crisis. Failure to do so will be detrimental and doubly impact on those countries facing a liquidity crisis.

  26. observa
    October 13th, 2008 at 16:31 | #26

    Sounds like the stirring trumpet call for a Summit of the good old Axis of Evil there Michael. Big Govt/Biz/Unions all coming together in one big love-in while the battlers get to sing God save the Queen and pass the vaseline!

  27. October 13th, 2008 at 17:41 | #27

    There is no such newspaper as the “London Times”, and never has been. The British newspaper the Times was the original and so never had its name qualified like its imitators, e.g. the Irish Times, the Times of Calcutta, the New York Times and so on.

  28. Michael of Summer Hill
    October 13th, 2008 at 18:00 | #28

    John, if I may respond to Observa by saying others are of a similar view requiring governments to do much more. HSBC argue that as reality sets in, “the worsening global financial crisis will prompt Asian governments to draw up more measures for fiscal pump-priming as well as incentives for domestic investment and consumption to brace for dwindling inflows from exports and foreign capital”.

  29. tflip
    October 13th, 2008 at 19:56 | #29

    And where does the oversupply of capital fit into all this? And how ironic that so much of that is in the sovereign wealth funds of communist China and only just out of communism, but we kept the authoritarianism, Russia. They will have to be careful to stop it melting into air though.

    I’m also quite partial to Keating’s description of the banks as mere utilities. Why do we need all those inefficient and moral hazarding overheads of shareholders and executives with share options anyway? Surely we could take advantage of the present opportunity to at least cull a large amount of them with a thoroughgoing nationalisation. Time to cut the threads of every golden parachute.

    As to ways to refloat the economy, here’s to a solid dose of inflation to create a bit of intergenerational wealth redistribution, and alongside that a big increase in benefits to those with the least. Rationally the best means to stimulate the economy from the bottom up with a bit of basic consumption. And finally, if you gave the unions back at least a small amount of power they could shift the capital/wage ratio back towards something both more efficient and more human.

    However
    (a) None of this will do much about climate change.

    (b) capitalism is a system of power not the mere market economy its ideology disguises it as. So the policies above are the least likely to get backing. But two cheers for the market for at least partially de-stabilising those vested interests. Smith was not all wrong.

  30. observa
    October 14th, 2008 at 00:04 | #30

    “..here’s to a solid dose of inflation to create a bit of intergenerational wealth redistribution, and alongside that a big increase in benefits to those with the least. Rationally the best means to stimulate the economy from the bottom up with a bit of basic consumption.”

    You need to bear in mind here tflip that it was a good dose of monetary expansion(those long low interest rates) that began the inflation in assets and fuelled consumption on credit. Those malinvestments have created a housing affordability crisis and hollowed out real production. Ask those Chinese SWFs where the opportunity cost of that forgone investment is now?

    So now Rudd subsidises bank profits and shareholder value and when Turnbull essentially queries throwing good money after bad he replies that essentially the authorities that have recommended such policy will see to it. The same authorities that oversighted all that money creation, etc. I agree with Marc Faber(Lateline)that this is really sending in the clowns.

    Lastly, it sounds like Turnbull’s on the same wavelength as you regards increasing pensions and bringing forward tax cuts, re bottom up consumption for the needy.

    The overarching lesson is that monetary inflation is noone’s long term friend but once let out of the bottle it’s extremely hard to pop the nasty genie back in again. It’s a long slow process and don’t be fooled by false dawns in that regard.

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