October 15, 2008 | posted by Michael Baxter in banking rescue plans | comments (0) |

Earlier this week, the Nobel Prize in Economic Sciences was awarded to a Bush-bashing, Gordon Brown-loving American.

Paul Krugman, Professor of Economics and International Affairs at Princeton University, and a regular columnist for the New York Times, has made many fans and critics over the years. His fans love the way he has used his New York Times column to lambaste Bush and US economic policy. His critics say he seems to be running a one-man, anti-Bush show.

But his Nobel prize was awarded for something more important than all that.

First of all, he worked on something called New Trade Theory.

As you know, right now, US politicians are screaming blue murder at the injustice of developing countries still growing behind a wall of protection and subsidies, while US companies suffer.

You can see the argument. In some parts of the US, in areas that are reliant on the auto industry, economic depression has already descended. It is not fair, they say, we are losing jobs, not because manufacturers in other countries are more efficient, but because they are subsidised.

But, there is another side to the coin.

You may be familiar with the Law of Comparative Advantage. This is the law which is supposed to show, beyond all doubt, that free trade is best and that any tariffs are bad. The law is possibly the most important economic principle there is.  It shows that it pays for two countries to trade with each other, even when they produce exactly the same goods and one country has an absolute advantage in every single product produced.  What counts, instead, is relative, or comparative advantage. So, for example, it makes economic sense for a high-powered lawyer, who happens to have a knack for cleaning, to pay someone to clean his house, even though a cleaner may take longer than the lawyer to make the house look all pristine.

There is a snag with this argument, however. It does not take into account economies of scale.

Any new business will always struggle to compete against traditional business, because it is simply not big enough to enjoy the full benefits of mass production. It is at a disadvantage against the larger company.

And that is why, it is argued, it does make sense to protect infant industries.

Krugman then took the idea of New Trade Theory and asked why it is that some countries export and import similar products? Why does Japan export Toyotas and import BMWs? Why does Sweden import Volkswagens but export Volvos?

The answer lies, in part, with economies of scale.

The public want variety. But as companies specialize and grow, and then exploit further economies of scale, each company becomes a specialist in its own niche. And BMW becomes especially good at producing BMW-type cars, but not so good at Japanese-type vehicles.

Krugman also looked at why individuals might move from towns to cities. Again, it seems to have a lot to do with economies of scale, with the specialist pool of labour on tap in a city, accentuating its own advantages.

Krugman’s theories are not easy to understand. He himself said they are: “… pretty well incomprehensible to laymen.”

But this is the curiosity: Krugman has done something that has left many economists fuming. He has talked to the mass market, and tried to express his theories, including other less academically oriented ideas, via his newspaper column.

Some see the Nobel award as a kind of posthumous award, for a former economist who has become a populist..

The truth is, those criticisms are themselves arrogant. Some academics become too precious by far about their discipline.

Krugman has had very little good to say about George Dubya, and was one of the economists who warned most vociferously that there was trouble ahead. This has not endeared to him to many.

As for Gordon Brown, he has heaped eulogy on Brown’s banking rescue plan. Earlier this week, his Monday column for the New York Times began with the sentence: “Has Gordon Brown, the British prime minister, saved the world financial system?”

He said: “The Brown government has shown itself willing to think clearly about the financial crisis, and act quickly on its conclusions. And this combination of clarity and decisiveness hasn’t been matched by any other Western government, least of all our own.”

Mind you, Krugman is also a big critic of Gordon Brown’s friend, Alan Greenspan.

He also argued in his recent New York Times post that the George Dubya regime has effectively driven out “knowledge professionals”, meaning there was no one left at the US Treasury “with the stature and background to tell Mr. Paulson that he wasn’t making sense.”

October 14, 2008 | posted by Michael Baxter in banking rescue plans | comments (3) |

As Gordon Brown and the members of his politburo sat and cogitated this weekend, they hit on a formula to do the impossible. They introduced a socialist programme to the world, the likes of which had not been seen since the years after the Tsar was toppled from Russia; yet in the process had the arch proponents of capitalism gushing their approval like best-behaved school children.

“The French state will not let a single bank fail,” said comrade Sarkozy. “We have placed the first foundation stone of a new financial order,” said comrade Angela Merkel. Meanwhile, from across the pond, comrade Paulson is said to be planning to re-channel some of his $700bn into a Chairman Brown type scheme, with the US treasury picking up equity in US banks it rescues.

The proletariats are of course chomping at the bit. Brown’s legions of supporters, the likes of the Daily Mail, with their anti-spiv agenda, want to see the greedy bourgeois bankers carted off to the mines, or, better still, forced to take up proper jobs like teaching maths.

And the suitably humbled former aristocracy who value their jobs, join the revolution. “Future profitability and capital generation will be optimised by placing a greater emphasis on risk-adjusted returns,” said a RBS statement.

“Reward for Board Members will take into account internal relative compensation packages and perceived fairness in the current economic climate,” said a Lloyds HBOS statement.

The Cossacks are not all taking it lying down. At Barclays, John Varley said: “We want to protect the right of self-determination,” and warned that banks that are nationalised will be “… constrained in their strategic and operational flexibility.”

But there is no stopping comrade Brown. At last he can ensure banks are run his way. Less risk, of course, but more loans for small businesses. No bonuses for senior management at the banks in year one. Future rewards will be in the form of shares – thus ensuring bankers are rewarded for the long-term benefits they bring in.

There’s nothing wrong with those aims. They are all perfectly laudable. Well done, Gordon, you have managed to ensure bankers behave like responsible brothers in future.

Then there’s the housing market. As you know, British house prices never were over-valued. Of course in Spain and in America it was different. Sure, average house prices to average income hit a much higher ratio in Britain than in the other two countries. Sure, debt to GDP was much higher in Britain too. But that isn’t the point. The US and Spain witnessed extraordinary house building booms, creating too much supply. That’s why house prices are falling there. In Britain, there was no debt bubble, because rising debt was covered by rising property values. Comrade Brown pointed it out to his foolish family of British citizens yesterday. “I think the housing market in Britain therefore has a better chance of starting more quickly again than the housing market in the States.” Not only does he want to see government-owned banks lend more to business, but he wants to see them provide more loans to home-owners too.

But consider this. What happens when a major employer, especially a major employer in a region where there is a marginal labour seat, runs into financial difficulty and its state-owned banks refuse to give it a loan?

Do you think the government will start imposing limits on top salaries at the banks? If they do, does this mean they will no longer be able to attract the top talent? Well, the legions of bank critics already have their answer to that question. “So what, it was this talent that created the mess in the first place.” But then, as was told here yesterday, the true cause of the credit crunch was a lot more complex than a few crazy bankers getting greedy. And it was those same crazy bankers who provided the funds to fuel Britain’s longest-ever economic boom.

And what about risk? Has anyone spotted the contradiction? Brown wants banks to lend more to home-owners at a time of a housing crash. Does that strike anyone as being a tad risky?

And supposing the £37bn of taxpayers’ money is channeled into providing more mortgages, and somehow the great house price crash is stopped in it tracks. Do you really believe the danger will have gone away? For as long as the ratio of house prices to average income is so high, there will always be a danger of a crash, and if somehow government action can stop house prices prices from falling now, they will merely be creating the roots for the next crash –  which will be even more dangerous.

And who is to say lending to business is not risky? Isn’t reducing risk the whole point of derivative trading and credit swaps? Surely it came unstuck because house prices stopped rising. It was actually Chancellor Brown who encouraged the development of a UK housing bubble.

The future must be bright for those banks that managed to stay free of government clutches. The likes of HSBC, Barclays and Santander must be laughing all the way to the …, well, to the bank.

Look, the government plan revealed yesterday was the right plan; the action announced yesterday around the world to take similar action was the right move.

But it is only the right move if it is seen as an emergency and temporary effort to stop a catastrophic banking collapse. If instead it is used as an opportunity to recast banks in Gordon’s image – or worse, ensure they are run in the way Daily Mail readers would expect, then the result will be disaster. Gordon is famous for his micro-management style. He is famous for wielding the weapon of complexity to enact his policies. Will it be like that with the banks too?

Yesterday he kind of compared himself with “far-sighted leaders like Roosevelt and Churchill”. But he undersold himself in putting himself up there in the pantheon of the world’s great leaders; he forgot to mention Lenin.

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October 14, 2008 | posted by Michael Baxter in banking rescue plans | comments (0) |

Yesterday was a day of celebration. If George Dubya is right, and the economy is suffering from a nasty hangover, then yesterday saw the greatest mass consumption of hair of the dog ever seen.

The Dow Jones soared 936 points, the biggest one-day rise ever. Even in percentage terms it was the biggest one-day jump since the volatility of the 1930s.

This morning, in Japan, the Nikkei went one better, rising 14.2 per cent.

And why? Why have the bulls come out stampeding? It was down to the most extraordinary series of government announcements, revealed yesterday, seen since …, well, since in peace time.

The Germans are pumping 500bn euros into their banks. Of that total, 400bn is being used to inject liquidity into the inter-bank market, and 100bn euros is being used to re-capitalize banks, in return for strict pay limits on the men and women at the top of German banks. Talking of women at the top, Angela Merkel said: “The package passed by the German government will serve the financial system and ought to serve to protect the citizens and not just serve to protect the banking system.”

In France, 350bn euros are being put on the line, of which 40bn will be used for re-capitalising banks. President Sarkozy said: “The French state will not let a single bank fail. We have to unblock the interbank market because money has stopped circulating, but it is a reasonable bet that by offering this guarantee, it won’t actually be needed.”

Spain is pumping in 100bn euros, Austria 85bn, Portugal 20bn; you know, it all adds up to a tidy sum. Not all countries are following the same formula. The Spanish reckon their banks are solvent, so their money is being used solely for creating liquidity

Then this morning, down under, the Aussies revealed a plan to provide 10bn Australian dollars directly to pensioners and low and middle income earners, and Australian first-time-buyers.

Later today, it is expected the US will announce their own plan, with around $250bn of the $700bnn package already authorized by Congress, to be used to re-capitalize US banks, in return for equity.

Some are hailing French finance minister Christine Lagarde as the hero of the hour, for it was she who managed to bring together the French and American sides, no easy task. Although, nearly headless Nick Sarkozy couldn’t resist jibing: “United Europe has pledged more than the US.”

The markets just loved it, of course, and don’t be surprised to hear European shares soar today.

But here is a question for you to ponder. If nationalizing the banks is such a good idea, and gets markets so deliriously happy, why didn’t anyone do it sooner?

Is it possible, just possible, that markets are overreacting?

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October 14, 2008 | posted by Michael Baxter in banking rescue plans | comments (0) |

Well, if you had been living on Mars for the last few months and returned to planet Earth unaware of what had been going on, then you would only need to hear this one snippet of news to realize something extraordinary had been happening. The Bank of England is lending £100mn to Iceland.

Or to be precise, the Old Lady of Threadneedle Street is providing £100mn to the recently nationalised Icelandic Landsbankibank. And that’s good news for 300,000 British savers who had money in the bank’s subsidiary Icesave.

Meanwhile, of course, Philip Green is trying to buy himself an Icelandic company called Baugur. So, if he is successful, the retail magnate will add stores such as Hamleys, House of Fraser, Jane Norman, not to mention a 49 per cent stake in Mosaic Fashions, which owns Oasis, Principles, Karen Millen, Warehouse and Coast, to his own empire consisting of BHS, Arcadia and Top Shop. Appropriately enough, Mosaic Fashions also owns supermarket chain Iceland.

Speaking on behalf of British savers, Alistair darling said: “Our authorities have set up an arrangement, agreed in principle, for an accelerated payout to depositors.” He added: “We are also working with the Icelandic authorities to facilitate claims by UK charities and local authorities on their deposits held at these Icelandic banks.” So it is a kind of carrot and stick. On one hand, it’s give us our money back, or else. On the other hand, it’s here is a £100bn loan.

Speaking on behalf of the poor old shoppers, who must fear some of their favourite stores could be sunk by a massive iceberg, Philip Green told Sky News: “I’m not interested in these businesses falling over at all, that will not help… This is 10 weeks from Christmas.” He added: “I’ve spoken to the management… If necessary, on certain circumstances, if the need came, I would lend them some money.” What a nice man, putting the interest of shoppers first like that.

Meanwhile, negotiations between Russia and Iceland continue. Apparently, Russia wanted Iceland to mend fences with its good friend Britain before it would conclude a deal.

There is a snag. Iceland really has run up debts so massive, that it has limited options. It could repay debt and saddle its 300,000 population with debts so great that it will take a lifetime before they are paid off. It could hope everything goes back to what it was like. It could hope that Russia and America enter into a bidding battle as to who can own that icy island in the North Atlantic, or should it just write the debts off.

It seems its big hope is this. Thanks to its strategic position in the North Atlantic, Iceland, just like the banks, is too important to be allowed to fail.
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October 13, 2008 | posted by Michael Baxter in banking rescue plans | comments (1) |

The world changed this morning. It’s being called Super Monday. Until recently, governments around the world were mild mannered, back seat drivers. But they spent this weekend changing their attire, and this morning stepped out with red cloak flaring, x-ray eyes boring, steel in their veins.

It was perhaps the most dramatic weekend yet, and this morning will go down in history as a key moment in this saga. British taxpayers also woke up to the news that they now own RBS, and have big chunks of Lloyds TSB and HBOS.

But to tell the story of this most dramatic stage yet in this, the great crisis of 2008, let’s begin at the beginning. It is just worth remembering the sheer scale of share price losses last week. The FTSE 100 lost 21 per cent of its value, so too did the DAX in Germany. The Dow didn’t fall quite so sharply – down 18 per cent, but only because it suffered bigger losses the week before. In Japan, the Nikkei was down 24 per cent. But the losses were not restricted to the developed world. The last few weeks have seen shares crash across the world, in China, India and Russia.

Then on Friday, the IMF rattled a few nerves. Usually you have to read IMF statements two or three times before their true meaning sinks in. Not this time; they couldn’t have put it more bluntly. Yesterday (Sunday), Dominique Strauss-Kahn, the IMF chief, said: “Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”

At first, the signs from finance ministers weren’t good. They uttered lots of soft words, and talked about a five-point plan to save the banking system, but there was no real substance. To put it into boxing terminology, they talked the talk, but they didn’t seem willing to walk the walk.

But this morning it seemed to change. And it changed in the UK first.

RBS is to be on the receiving end of a £20bn government investment. Taxpayers will then own 60 per cent of the business, so, in effect, RBS will be a government-owned bank. So the government banking portfolio will consist of Northern Rock, Bradford and Bingley and RBS. Or, to put it another way, Nat West is now a government-owned brand. “There has to be a better way,” the Nat West used to say. Well, those words may have proven prophetic in a way that just wasn’t intended.

Sir Ron Goodwin, the boss of RBS, who presided over the purchase of ABN Amro, and insisted the bank would not need to raise more money, is out. His departure seemed to be about as inevitable as the forthcoming departure of Peter Mandelson, who is bound to succumb to the new media/union witch-hunt which has already begun.

HBOS is to receive £11.6bn, Lloyds TSB £5.5bn, and assuming the merger goes ahead the government will hold a 40 per cent stake in the new bank.

Barclays, which was lucky enough to fail in the battle to gain control of ABN Amro last year, reckons it can stay independent, and is raising £6.5bn from private investors.

However, so well has the plan gone down, that it appears private investors are coming out of the woodwork, and putting up a lot more money than was originally anticipated. It seems the government may not, ultimately, put up quite so much money, and its equity stake may be smaller as a response.

It seems likely governments in Europe will be announcing similar packages soon, and probably today.

The US government seems to be lagging behind the curve, but it has hinted at a similar scheme itself.

As a by-product of all this, Gordon Brown seems to be emerging as the key international figure. As was predicted here three weeks ago, in ‘Is Brown set to see his Falklands moment?’, the British PM may be achieving something that was considered unthinkable, and is restoring his political credibility almost as quickly as he lost it.

At the time of writing, stock markets have roared their approval, with sharp rises seen in the UK and mainland Europe. Frustratingly, US stock markets are closed today, so we will have to wait until Wednesday morning to shed light on the US reaction.

The British government has played this well.

But it is a mistake to think all the problems are behind us. Sure, the possibility of a global banking crisis, creating a global economic depression, leading to all kinds of dangers, has diminished.

Neither does it mean that the good times are here again. Nationalised banks, even partially nationalised banks, are not the best institutions to sit at the core of the global economy. Banks such as Barclays, HSBC and Santander, which are able to avoid giving away government stakes, could yet scoop up the cream.

And even if the banking crisis has seen its worst – and let’s hope it has – the real economy is only just feeling the effect. Hopefully, governments have taken an important step in ensuring the world does not see economic depression, but recession is unavoidable.

On the Today programme this morning, one stockbroker talked about recession as being a good outcome. Effectively he said at least we can deal with recession, we have seen it before, and we know it will pass.

Maybe, thanks to a quite impressive government accord, the worst-case scenario is now looking less likely. But this does not mean recession can be avoided – if governments can stop that from happening, then Superman really would have to run the show.

October 13, 2008 | posted by Michael Baxter in banking rescue plans | comments (1) |

As the governments rush in to to save banks, and as expectations of imminent big cuts in interest rates grow, a backlash is growing.

Many disagree. Why should greedy banks be rescued? If this is a debt crisis, then how will cutting interest rates help? Surely what is needed is higher rates to encourage savings.

Banks are not that popular at the best of times, and when people see their bank tottering, the sense of schadenfreude is almost palpable.

But these views are wrong. Indeed, they are dangerous. And this is why:

Back in the 1930s, the early 1930s, the US government did nothing. “Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate. This will in turn purge the rottenness out of the system,” said Andrew Mellon, US Treasury secretary. He also said: “High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”

The result of this, or at least partially the result of this, was the economic depression, and which led to a world war.

The UK did not suffer quite as badly as other economies in the 1930s, partly because Britain entered its own economic depression earlier than most other countries and thus recovered sooner. She also benefited by leaving the gold standard, and thereby letting the pound fall.

No one wants to be in this current mess. But to sit back and just let banks fail would be an act of gross negligence and, given what we now know, equate to the modern day equivalent of the Treaty of Versailles.

You just don’t want to think about what would happen if governments followed the course of action advocated by Andrew Mellon.

Interest rates are about to be cut. In the UK, some are predicting rates will fall to 2.5 per cent; in the US, to just ½ per cent. And, by the way, there’s more to a cut in interest rates than encouraging borrowing. It seems unlikely there will be another credit boom for a very long time, whatever the rate of interest. But there is a real danger that as the recession deepens, those in debt may go bust, and this could create a downward spiral. By contrast, a cut in rates will improve affordability levels for those who are struggling to make mortgage payments at a time of soaring energy costs, and worries over unemployment. It could help avoid a disastrous surge in repossession levels. If rates are not cut, repossession levels could rise to a level that would make the early 1990s crash seem like a walk in the park. Under those circumstances, it would be impossible to avoid a banking collapse.

October 10, 2008 | posted by Michael Baxter in banking rescue plans | comments (0) |

This is the weekend governments around the world will hopefully begin the fight back. How can the global economy get out of difficulty? What will they do? What are the dangers? What does the experience of the past tell us? 

Sometimes disaster can be a good thing. When the asteroid wiped out the dinosaurs, a gap in the market was created which got filled by the mammals. If it wasn’t for that asteroid, we would never have come into existence.

At the end of World War II many economies were effectively starting with a blank sheet. World War II wiped out infrastructure, but it didn’t wipe out knowledge. The post-war period to the early 1970s was the most successful period ever recorded by the global economy – that’s ever.

Destruction can be good. The great Austrian economist Joseph Schumpeter used to refer to great gales of creative destruction. He also feared what he called corporatism, which was a kind of collective economics in which unions, management and government work together in a cosy relationship of stability in which failure just never occurs. He said corporatism would ultimately lead to the collapse of capitalism, and presumably, wealth creation.

But there is a snag with all this. The social cost of 1930s-type failure is just unacceptable. Bear in mind, also, that World War II was probably the result of the Great Depression.

There is a good economic argument to say that banks should be allowed to collapse, that government should stand back, but the benefits won’t emerge straight away, and the hardship and dangers that could thus emerge are such that, well, you just can’t let it happen.

Then again, the Internet and other forms of mass communication are such that any recovery could be almost as dramatic as the crash.

Some people say Schumpeter was the greatest economist of the 20th century. His big rival for that epitaph was, of course, Keynes.

Capitalism in its purest form may thrive if failure is allowed to occur, but only in the long term. Keynes once famously said: “The long run is a misleading guide to current affairs. In the long run we are all dead.”

His big idea for ending economic depression was demand management. He advocated measures to boost demand through government borrowing. In the US, Roosevelt sort of half-listened to Keynes, and the New Deal was the result. But many of Keynes’s supporters argue the New Deal did not go far enough, that it was half-hearted. Ironically, they say it took World War II, and the massive government spending that entailed, to create the kind of fiscal stimulus Keynes advocated. And that was why the depression finally ended.

The other side of the argument says that the depression was ending anyway. Classical economic theory says that when demand is low, wages fall until it becomes profitable to employ people again. Give it time, goes the argument, and this will happen.

What we really need is a halfway house.

Bizarrely, the financial crisis we are seeing may well lead to the creation of a new economy that really is something special. An economy that builds upon innovation and technology, and that has learnt that economic growth is down to the goods and services we produce, not down to shuffling money – or down to booming house prices.

Frankly, we have already passed the point of complete failure. Even if Mr Brown and Co wave a magic wand, and shares go back to normal next week and credit is restored into the markets, things will never be the same. A gale of creative destruction has already blown through the financial system.

Now is the time for a global, organised fight back. It seems the US is considering introducing a Brown/Darling type scheme –  in which the US government takes equity in banks. It was argued here this should have been done in the first place.

Last night, the Dutch government announced a 20bn euro plan to provide capital to firms that are “fundamentally sound and viable.”

The G7 are meeting; the IMF is pontificating; the World Bank wants action.

It is like that scene from The Life of Brian – you know, when speech after speech says now is the time to stop talking, and do something.

But action will follow; expect major announcements this weekend.

Modern technology has in many ways hastened the speed of this crisis. Rumours spread like never before. Now, technology can be used to create the fight back.

This is not the end of civilization, neither is it the end of capitalism. The global economy will come out of this stronger as a result – unless, that is, governments throw a blanket of control and regulation over the system. You can understand how Schumpeter’s corporatism will emerge from the ashes of this crisis – and that would be a bad thing.

Markets rise too high, they then fall too far. But that pattern is not restricted just to markets. It defines human nature. The real danger lies not so much in how serious this crisis is, it will come to an end. The real danger lies in the overreaction that then follows, and whether the inevitable public reaction strangles the lifeblood out of what could be the most sustainable and impressive economic boom seen yet.