Jeremy Warner's Outlook: Treasury fiddles as markets crash

So is that it? Yesterday's statement by the Chancellor on the financial crisis was so completely underwhelming as to be barely worth reporting. There was no sense of the urgency required to prevent this already cataclysmic banking crisis from turning into an economic disaster. We have to assume that behind the scenes, the Treasury is beavering away on some grand economic recovery plan, which will include, as widely suggested, the recapitalisation of banks with taxpayers' money. But if it is, the Chancellor is saying little about his planned response. Leading bankers were again summoned to Downing Street yesterday afternoon, but few of them yet accept that the Govern-ment should be allowed to take controlling stakes by investing in preference shares, as one option being considered by the Treasury suggests.

Meanwhile, in the real world outside the corridors of Parliament and Whitehall, things are becoming ever more ugly. I'm not talking here about stock markets, which are mere baro-meters of the prevailing mood among investors and therefore a frequently misleading guide to eventual outcomes. Yet share prices do send out important signals and right now they are pointing to a major calamity in the making. So destructive has this storm in the banking system become that it is no longer any exaggeration to say that without the correct policy response it is certain to plunge the world into severe recession or even depression.

Related articles

• Banks set to agree £50bn package
• Royal Bank of Scotland shares battered again
• EU-wide deposit guarantee agreed
• Worries for UK internet savers as Icelandic bank is nationalised
• Landsbanki's nationalisation explained
• Alliance & Leicester fined £7m over insurance sales
• Brown pledges to maintain financial stability
• UK 'already in recession' claims business group
• Bhs trading 'unpredictable' as sales fall
• 20 reasons for the crunch
• Leading article: The day Britain and Europe shared each other's pain
• The day fear hit the markets
• Iceland suspends bank stocks as krona plunges
• Wall Street space man to pilot $700bn mortgage rescue plan
• Contrite Lehman chief defends 'excessive' bonuses
• Business leaders call for half-point interest rate cut this week
• From Iceland to Greece, Europe marches out of step
• After the worst day at the office, the traders headed for the pub
• Zoellick says G7 should be replaced
• Michael Bloomberg: Our response to the financial crisis should be modelled on 9/11
• Darling may raise deposit protection
• Bank of America to raise $10bn and cut dividend
• Brits covered by UK pledge over Iceland deposits
• Simon Carr: Gordon looks happy. Time to panic
• Brown hosts talks on economic crisis

Even a month ago, I would have regarded this as an extreme view which was highly likely to be proved wrong-headed. Yet events have since moved with terrifying speed and there is now a very real chance of them ending very badly indeed. Despite the urgency of the situation, the Chancellor's statement said nothing new and failed to provide the confidence required that the Government is on the case. As suggested in this column last week, an urgent and bold policy response is called for, including deep cuts in interest rates, public money for recapitalising banks, state guarantees for deposits, and further liquidity on non-penalty terms, provided either by buying up illiquid assets, as planned in the US, or by lending against them, the approach so far pursued in Europe and the UK. As markets yesterday signalled, even this may not be enough.

In any case, there was little evidence in the Chancellor's statement of the policy response required, beyond repeating the Bank of England's commitment to provide markets with all the liquidity they need. Mr Darling promised more, but insisted that providing a running commentary on what was being considered would only contribute to the uncertainty in what were already overly febrile markets. Yet time is running out. The Chancellor doesn't have the luxury of a fully matured response. He must act now. I don't want to dwell unduly on how we arrived at this potentially catastrophic state of affairs. There is an excellent 20-point analysis of the causes on page 41. Yet there have plainly been failures of judgement and theory in the policy response thus far. The most serious of these in my book was the decision in the US to let Lehman Brothers go to the wall.

In doing so, the judgement made by the US Treasury was that Lehman's was of little or no importance to the US economy, and could therefore be allowed to fail as a lesson in moral hazard to wicked Wall Street bankers. Lehman was to be held liable for the consequences of its own recklessness, folly and greed. How wrong can you be?

In fact, there were no lessons of moral hazard for Wall Street bankers in the Lehman's collapse. Most of them, in the US at least, have ended up keeping their jobs and their bonuses. In the meantime, equity holders, many of them representing pension money and other forms of saving accounts, have found themselves completely wiped out.

There is now extreme reluctance among investors to participate in the recapitalisation of the US and European banking system, leaving governments with little option but to underpin confidence by injecting taxpayers' money instead. Yet the more serious impact of allowing Lehman's to go to the wall has been to create the conditions for a classic domino sequence of failing banks. When Lehman collapsed, more than $400bn of assets belonging to others became frozen in the system. This has made those lending to other banks with assets which have become frozen feel even more unsafe about their money. Many have dashed to get their money out, for there is no telling who might be next.

When there are big withdrawals, a bank can normally simply borrow from another to meet the demand, but, because banks no longer trust each other, the interbank money markets have all but dried up. One failure thus threatens to lead to a string of others.

Similar policy mistakes were made in Britain over the collapse of Northern Rock. Rather than support the bank with the liquidity it needed, or provide the government guarantees that would have enabled a smooth takeover, Northern Rock was demonised as a bad bank whose reckless expansion deserved to meet its nemesis in nationalisation without compensation. As events have proved, Northern Rock was, in fact, only the outrider for a funding problem that would become common to the banking system as a whole.

I was virtually alone in the British press in arguing this point of view at the time. The problem was largely one of the Labour Government's own making. In the 1998 Banking Act, many of the liquidity requirements that had governed the banking system were abandoned.

Banks were instead encouraged to use the wholesale markets to grow their balance sheets and given to understand that if they suffered liquidity problems, they could always fall back on the Bank of England's lender-of-last-resort facility, which would support them through their difficulties. Again, how wrong can you be?

That's not to say that policymakers have got it wholly wrong. Much of the policy response, including the Paulson plan to buy bad debts, has been broadly appropriate. Yet there have also been some unfortunate mistakes which have only succeeded in making a bad situation worse.

If it were only the welfare of bonus-driven bankers that was at stake, nobody would care. Unfortunately, the crisis now threatens to do extreme damage to the rest of the economy. If banks cannot pay each other, then eventually they won't be able to deliver cash to their customers either. Bills won't get paid, there will be multiple defaults throughout business, companies will go bust and employees will lose their jobs. It sounds like apocalypse, but it is regrettably becoming only too possible.

At the start of the crisis, the authorities were reluctant to provide the banking system even with the liquidity it needed. This was particularly the case in Britain, where the Bank of England made a key mistake in extending the idea of moral hazard from solvency issues to those of liquidity. Like everybody else, the Bank has been on a sharp learning curve, and it has since managed to get the liquidity issue right.

The problem is that issues of liquidity and solvency are binary. If there is an absence of liquidity, then banks need a lot more capital to finance their lending. What's more, they could find their profits wiped out by the bad debt problem that would emerge in a serious recession, and would in such circumstances need even more capital to underpin confidence.

If private investors won't put new capital into the banking system, then the Government may be forced to instead. It might have been possible to avoid this outcome, but it's probably too late now. Governments have got themselves into a position where they must bail out the banking system on all three fronts. They must provide liquidity, buy bad debts and inject new equity.

In doing so, banking will return to the way it was 30 or more years ago, when many continental banks were nationally owned. Even in Britain, banks were regarded as more like utilities than businesses. Large parts of the system – TSB and the building societies – were mutually owned and there was an implicit contract even with the big commercial banks that they would bend behind the Government's economic objectives.

Already, the beginnings of this back-to-the-future world are apparent in the current wave of nationalisations. As governments move to recapitalise banks by taking stakes in them, banks will again become more politically directed, heavily regulated and constrained in what they do. I realise that it is not part of the zeitgeist to say so, but it's not altogether clear that this is a healthy development. It seems to me that having the politicians in charge of credit allocation is likely to produce an even worse outcome than the markets. The tragedy is that it may have become an unavoidable one.