Stephen King: Market convulsions will lead to the return of the state as a major economic force
Monday 28 January 2008
When the dust settles on the financial market mayhem of the last few months – mayhem which degenerated into an extraordinary convulsive fit last week – one consequence will, I suspect, stand out from all others. We will say goodbye to unfettered free-market capitalism and the minimal state.
Even before the latest financial crisis, the political mood was shifting. Concerns about the environment, income distribution and migrant labour were all adding to doubts about the free-market model. Now, though, we may be on the verge of an even bigger change. Having been rolled back over the decades, we are, I think, about to see the return of the state as a major economic force.
Indeed, the financial crisis has already, perhaps inadvertently, led to much bigger state involvement in our economic affairs. As Citigroup, Merrill Lynch and others have sold off chunks of their businesses to the Chinese, the Singaporeans and the Gulf nations, we've begun to recognise that sovereign wealth funds have the ability and the willingness to own big shares of supposedly free-market companies.
This, in turn, raises an obvious question. What if the major shareholders in a company don't fully subscribe to free-market tenets? Years ago, the Thatcher government argued in favour of privatisation because it exposed company managements to capital market discipline. This argument only works, though, if those within the capital markets are interested in maximising their financial returns. It's not clear that all sovereign wealth funds will act in this manner.
If they don't, how should western governments react? The obvious answer is to regulate to ensure that the interests of other stakeholders – consumers, workers and other shareholders – are met. But this, surely, is just another form of state intervention. Regulation is unlikely easily to be able to mimic free-market outcomes – in part, because such outcomes are, for good or bad, unpredictable – so the ultimate result is, presumably, an escalated level of state involvement.
This, though, is probably not the most important consequence stemming from the recent financial market turbulence. In many ways, the involvement of the sovereign wealth funds has been a stroke of good fortune. Banks desperately short of capital might otherwise have had to resort to fire sales of assets and, even worse, rights issues. That, in turn, would have weighed even more heavily on the world's bourses.
No, the biggest consequence, I suspect, is the return of state involvement, whether voluntary or otherwise, in each nation's domestic macroeconomic affairs. Over the last few years, we've got used to the growth of international capital markets, with ever-increasing cross-border capital flows. For a while, this meant that sub-prime households in the US, for example, could borrow indirectly from, say, local councils in Norway. The device linking these seemingly disparate creditors and debtors was, of course, global capital markets and, in particular, the huge growth in recent years of asset-backed securities.
When, however, trust falls out of the bottom of the market, as has happened in recent months, who ultimately is responsible for sorting the problem out? Is it the banks, which originated and then sold off so much toxic paper? Is it the households who shouldn't have borrowed so much in the first place? Or is it the Norwegian local councils and their ilk who perhaps should have been more aware of the risks they were taking when buying increasingly exotic financial products?
The truth, of course, is that while each of these has an interest in finding a solution, none of them, on its own, is probably capable of doing so. The weakness and enhanced volatility of capital markets in recent months has been a consequence of a monumental collapse in levels of trust. Whether it's corporate bonds, asset-backed securities or, more recently, equities, investors no longer see any of these assets as a safe store of value.
Only one group of assets is seen as trustworthy at the moment. Whether in the US, the UK or the eurozone, government bonds are in hot demand. Yields are remarkably low. For a fleeting moment last week, US 10-year Treasury yields dropped to less than 3.3 per cent, a level almost without precedent. No one, these days, is looking for decent returns. They're much more interested in keeping their existing capital safe.
It's for this reason that governments will have a bigger role to play. If government yields are so low, governments can borrow from the capital markets cheaply and easily. Whereas both households and companies are succumbing to the credit crunch, governments have no such constraints. They can readily get access to funds. As a result, they may find themselves playing a much bigger role supporting economic growth.
The Americans already appear to have recognised this turn of events. With remarkable speed, Congress and the Administration have come up with a fiscal package worth over $100bn, enough to add about 1 per cent to economic growth, even though the American fiscal position is nowhere near as healthy as it was ahead of the 2001 downswing. This stimulus plan may not be enough to avoid recession, but it should certainly help to limit the scale of any initial economic contraction. Elsewhere, though, there is no such debate.
Arguably, of course, this reflects America's unique economic problems. The housing market is imploding, unemployment is rising and many of the usual recessionary indicators are flashing red. The same cannot yet be said for the UK or for countries within the eurozone.
It may, though, only be a matter of time. The sub-prime crisis started in America but the systemic risks to the financial system are transatlantic in nature. Failing capital markets carry consequences for economic growth on both sides of the Atlantic, and to pretend otherwise would be foolish.
If, though, we're going to deal with the crisis, a fundamental rethink of the relationship between fiscal policy and the broader economy may be required. Broadly, two arguments favour low and stable budget deficits. First, low deficits are consistent with the maintenance of price stability (the bigger the budget deficit, the bigger the incentive for governments to turn on the printing press to avoid having to raise taxes or cut back on government spending). Second, low deficits provide freedom for the private sector to allocate capital efficiently (because governments cannot be trusted to do so).
Yet these arguments are not universally true. Banking crises tend to be associated with persistent periods of weak demand and, hence, low inflation. And when capital markets fail, their failure is typically the result of earlier periods of inefficient capital allocation (think of the late 1990s dot.com bubble, the Japanese land price bubble of the late 1980s, or America's savings and loans crisis). In other words, there are times when governments really do need to borrow – and borrow in size – if a calamitous economic downswing is to be avoided.
Are we reaching another of those occasions? Quite possibly, yes. American policymakers have already half-admitted this. In other countries, the debate hasn't even started. It must, though, before it's too late.
The UK avoided the last global recession in 2001 largely because of an earlier, fortuitously timed, loosening of fiscal policy. Back then, though, the starting position was a lot better than it is today (see chart): a healthy budget surplus which allowed plenty of room for increases in public spending without breaking the then Chancellor of the Exchequer's golden rule. Now, though, the UK has a big budget deficit. Should Alistair Darling, the current Chancellor, stick to his predecessor's rules? Perhaps, but he should at least know that financial markets would be unusually forgiving were he to decide that the current crisis has rendered those rules defunct.
Stephen King is managing director of economics at HSBC email@example.com
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