How to get out of the credit crunch

Enough credit? (picture Lotus Head)

An enquiry responding to the previous blog post on the credit crunch here asks, if the case for international action is proved, what that international action should be. And would membership of the euro help?

In answer to the first part of that question, the immediate priority is to stop trouble spreading further. Only after that is it possible to make the changes that will stop trouble coming back.

And the biggest part of the trouble at the moment is that banks are unwilling to lend money. It started because a few banks found they had lost money and could not repay their debts. The losses then spread, because the banks who have lent to the ones that have lost money also lose money because those loans they have made cannot be repaid. In this way, the bad debt problem is infectious.

What makes matters much worse is the fear that follows from this infection: when banks become uncertain about whether loans they might make will be repaid, they stop making loans. As a result, business activities that depend on borrowing grind to a halt. This includes a lot of what goes on in the financial markets, but also a lot of what goes on in the real economy too. Almost everyone who buys a house does so by borrowing: if loans are hard to obtain, it becomes hard to buy a house and, as a result, hard to sell one.

So, the first thing to do is to ensure that banks are willing to lend money again. Even if they are financially healthy, they have become ultra-cautious. Giving them renewed confidence means guaranteeing the deposits made by individuals in their bank accounts, which only the government can do, and lending money to those banks which are willing to make loans (in theory they all should be, because that is how banks make their profits), which is what central banks can do. If this happens, then the knock-on effects of the bad loans that started the crisis can be kept to a minimum.

The next thing is to deal with the banks that have made those bad loans. One bad debt can start a cascade through the banking system, when each bank finds itself unable to repay its own creditors because its debtors cannot pay it. In order to prevent these bad debts from knocking over banks like dominos, governments have to resort to bailouts. These bailouts are controversial because, to a greater or lesser degree, they compensate banks for having made bad decisions, and these bad decisions do not come from nowhere. They are the result of deliberate strategies adopted in order to earn greater profits, but on the other side of the greater profits is the greater risk of losses. The bailout in effect makes good the greater risks that have been run: it is paid for by all taxpayers, including those who have deliberately run fewer risks and accepted lower profits as a result. Is this fair? This is the controversy.

The accepted reason is that banks are so important to the economy. If the sandwich bar near my office makes some bad financial decisions and goes out of business, I have to walk a bit further to get a sandwich but I will not go hungry. If a bank goes out of business, and in particular if a lot of banks go out of business, lending might grind to a halt. So many other business activities are dependent on the continuation of bank lending that it is worth putting up with the unfairness. That is the argument and it undeniably contains within it a certain amount of unfairness. It was this unfairness that led the Republicans in the US House of Representatives to reject the first bailout proposal last week.

Now, all of this, whether the guarantees or the bailouts, has to be coordinated internationally.

On the guarantees, money can flow around the world very easily and will be attracted to the banks with the strongest guarantees away from the ones where the guarantees are weaker. The existence of guarantees of different strength in different European countries will therefore distort competition within the single market. It will also tend to encourage the guarantees given to get stronger and stronger, as each member state struggles to keep up with and maybe gain an advantage over all the others. Acting together, they might not need to make such extensive guarantees (and guarantees are expensive), but each acting on its own puts them all in a weaker position.

Regarding bailouts, the considerations are different but the need to act internationally remains the same. The decision about whether or not to bailout any individual bank, and if so what conditions to impose, will be based on an assessment of the consequences of not bailing out that bank. How bad are the losses? Who else might be affected? What might that cost? If the decision is made by a single national government, the costs will be borne by its own taxpayers alone, in which case it can be forgiven for only considering the costs of not bailing out within its own country. Any harmful consequences of not bailing out a bank that will be felt in other countries do not need to be taken into account. This of course is absurd: the financial markets are far too integrated for this kind of national analysis to make sense any more. All the consequences should be taken into account, wherever they might fall, before deciding whether or not to take action. It is obvious, also, that the costs of taking action should also be shared, if the benefits of taking that action will also be spread widely.

There is a further reason for collective action in funding bailouts, which is that national governments do not have an unlimited ability to pay for them, and there is the possibility that the most expensive bailouts might all be required in a country that cannot afford them. What then? Do I watch my neighbour’s house burn down, with the risk of it spreading to mine, because he has run out of water, or do I help fight the fire with whatever water I have, too?

It may well be hard for national governments to resist the temptation to pursue national strategies to fight the banking crisis, but resist it they must. A crisis that has spread across the whole of Europe and which could strike anywhere in Europe has got to be dealt with by the Europeans together. The consequences of getting this wrong could be very serious indeed.

The second question was whether being in the euro provides protection against the crisis. The immediate answer to this is that it does not, but the more nuanced answer is that it might. The fact that 15 countries now share a currency makes it easier to trade with each other and increases the economic integration between them. Perhaps this makes the crisis more likely to spread and not less, but on the scale that the banking markets operate, this probably does not make much difference.

The nuanced answer is that membership of the eurozone might also bring with it – and should also bring with, I might add – a greater awareness of the extent of economic integration and the need to take the big economic decisions in common. If this realisation develops, then the temptation to pursue national and inevitably inadequate responses to the crisis will be reduced and the determination to follow international responses will be increased. As with so many other aspects of political life, the European Union does not guarantee success but it does make it possible, whereas national policies, with whatever wisdom and insight they are conceived, are doomed to failure.

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