Stephen King: 'Capitalism can be incredibly unstable and state intervention is back, big time'

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The Independent Online

Phew! That was some week. Lehman Brothers, the American investment bank which opened for business back in the 1840s, has gone. Merrill Lynch has been swallowed up by Bank of America. Manchester United's shirts and AIG are owned by the US government. Lloyds TSB has taken over HBOS. And, on Wednesday and Thursday, it looked like we were on the verge of another Great Depression, with shares in all manner of companies in freefall, and banks the world over on the point of capitulation.

Then, as if finally to provide meaning to the over-used phrase that it's always darkest before the dawn, markets on Friday staged a remarkable recovery. The UK stock market, for example, rose almost 9 per cent on the day. The previously beleaguered banks led the way: HBOS and RBS up 30 per cent, Lloyds up 20 per cent and HSBC up 15 per cent. From apocalypse to acid trip in five trading days. Has the world gone mad? Not quite. Over the past few days, though, we've had a sobering reminder that capitalism can be incredibly unstable. The belief in free markets has taken a beating. State intervention is back, big time.

For students of economic history, none of this should be too surprising. Booms and busts are a persistent, if unpredictable, feature of free (and not so free) markets ("no more boom and bust" was always, frankly, a bit of a joke). Last week's threatened bust, though, was on a scale way bigger than anything in living memory. It looked like the financial system would completely implode. Japan may have had problems with its bank failures in the 1990s. The Asian crisis of 1997-98 was a truly awful experience for those involved. You have to go back to the 1930s, though, to find a situation resembling the experiences of the past few days.

Most people think the Great Depression was a consequence of the Wall Street Crash in October 1929. While partially true, it is not anything like the whole truth. The Crash triggered a desire to hold cash as opposed to riskier assets. This left banks, which typically raise liquid funds to invest in illiquid assets, in a vulnerable position. As panic spread, so more banks went bust. In total, there were four separate banking crises in the early 1930s, leaving the US economy starved of credit. Demand collapsed and unemployment soared; 9,000 banks went bust. At the peak, a quarter of the American workforce was out of a job.

Academic studies suggest that, had the banks not failed, the human cost of the Great Depression would have been much diminished. While there would still have been a deep recession, it would have been nothing like as big as the 30 per cent fall in output which actually occurred.

In another, academic, life, Ben Bernanke became one of the world's foremost experts on the Great Depression. It is, therefore, fortunate that he's in charge of US monetary policy today. It is also very good news that the Federal Reserve and US Treasury are working together to deal with the problem. In the early 1930s, the Federal Reserve jealously guarded its independence, refusing on moral hazard grounds to re-liquefy the financial system, a view which doubtless contributed to the subsequent economic collapse. It wasn't until the election of Franklin D Roosevelt at the end of 1932 that fiscal and monetary heads were banged together and it was only then that the US economy began to recover.

The scars left by the Great Depression span the generations. Mr Bernanke and Hank Paulson, his brother-in-arms at the US Treasury, have no intention of going down the same route again. Having spent the past year or so worrying about the balance between moral hazard and a banking bail-out, they have accepted that, for the time being, moral hazard will have to be put to one side. In Mr Paulson's own words: "We must now take further, decisive action to ... address the root cause of our financial system's stresses. The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy." Mr Paulson is proposing to use American taxpayers' money to buy up those illiquid assets, hoping that banks and other institutions will be able to trust one another again, thereby easing the credit squeeze which has done so much to imperil economies the world over.

That, at least, is the long-term ambition. In the short term – days, not months – the US authorities were terrified about the possibility of further bank runs. As levels of mistrust rose ever higher, bank failures were becoming a self-fulfilling prophecy. Having allowed Lehman Brothers to go bust, the US authorities appeared for a while to have launched a game of financial Russian roulette. Which bank might be the next to go bust? If you didn't know, you perhaps were better off out of the game altogether, a view which prompted massive share selling earlier in the week and, thus, fears of a Great Depression mark II. As I write, we can only hope that the Paulson plan will work. It will not be easy. Which mortgage assets will be purchased? At what price? Will the US taxpayer only be asked to buy the assets of American banks? What about foreign banks operating in the US? And US banks operating abroad? And will Congress agree to the plan?

The Paulson plan is, of course, based on the Resolution Trust Corporation (RTC) launched in 1989 to buy up the assets of failed Savings and Loans institutions. That, though, was a uniquely American problem. The Paulson plan will have to be a lot more ambitious. It will need global reach. And, to restore trust in the banking system, it will need to buy up assets from the balance sheets of banks which, until now, have just about remained both liquid and solvent.

While Friday's euphoria is understandable, the longer-term consequences of the crisis will surely require a more sombre approach. First, although the original RTC helped clear up some of the mess left behind after the late-1980s (when, for those who've forgotten, greed was good), the US economy still went into recession in 1990 and a genuine economic recovery had to wait until 1994.

Second, there is the cost to the taxpayer. It's difficult to know at this stage how many assets will have to be purchased but I reckon the bill will likely run into the trillions of dollars. Perhaps those assets will subsequently rise in value, leaving the taxpayer with a healthy profit. It's worth remembering, though, that the original RTC, and other associated funds, left taxpayers nursing a loss which in total amounted to well over $100bn.

Third, the 1930s left the world economy with a legacy of protectionism, capital controls and market inefficiencies which most economists think reduced people's living standards. The same could happen again. Fourth, having given the US economy the benefit of the doubt for years, perhaps foreign creditors will turn their backs on US assets, undermining the long-term growth rate of the world's biggest economy. The website of a now-defunct bank provides the unintentionally ominous boast: "The history of Lehman Brothers parallels the growth of the United States and its energetic drive toward prosperity and international prominence." You have been warned.



Stephen King is managing director of economics at HSBC

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