How much will the financial crisis eventually cost? I'm not talking about the billions of pounds or the trillions of dollars being spent to rebuild the world's financial system. These numbers are now so big that, in thinking about them, I feel decidedly numb. Moreover, the asset purchase and insurance schemes launched by governments may not cost that much over the longer term: not all the assets being purchased or insured against will prove toxic and a recovery in economic activity would probably leave governments and taxpayers nursing only modest losses. Indeed, with any luck, they might even make money.
Instead, I'm thinking about the economic and political costs likely to stem from the changing international economic order. Back in the 1990s, when no one had heard of sub-prime and Communism was on the way out, some were even brave enough to declare the end of history. Yet, as soon as free market capitalism appeared to have the upper hand, it blew its chance. Here we are, a few years later, with politicians of all tendencies demanding that "something must be done". But what? And can we be sure that quick fixes will not leave us having to cope with longer-term problems?
We might have a better idea by the end of the week, when the leaders of the world extricate themselves from east London's ExCel centre. Doubtless, any communiqué will offer platitudes: the benefits of co-ordinated stimulus, the need for better cross-border regulation and supervision and, most obviously, the desire to avoid protectionism. Making statements, though, is easy. The reality is more worrying. Let's take the co-ordinated stimulus. Already there is a sense that co-ordination is breaking down.
Mervyn King's comments to the Treasury Select Committee last week underlined the tensions between the Bank of England and the Government with regard to quantitative easing – too much government borrowing would leave the Bank fretting over the amount of money it should print to keep gilt yields relatively low. The European Central Bank doesn't quite know how to reinvent itself in a world where the barriers between monetary and fiscal policy are slowly coming down. And no one knows how much governments can afford to borrow before they are forced to go cap-in-hand to the IMF or end up having to think about defaulting to creditors.
These difficult debates are hardly surprising. We have spent 20 years arguing in favour of central bank independence and warning of the horrors of printing money. We have abandoned those ideas. The economic rationale is sensible – quantitative easing is an attempt to bypass the banking system in a bid to get credit to where it's needed. But there are costs involved.
If, for example, central banks are buying ever-larger amounts of private sector assets, they will have increasing influence on the cost of capital. The market, correspondingly, will have a smaller influence. Meanwhile, the market's early-warning system to indicate inflation will inevitably malfunction if the central bank is buying government bonds, thereby preventing yields from rising in response to rising inflationary fears.
Meanwhile, the enthusiasm for Keynesian fiscal expansion is waning in the light of horrendously large budget deficits, whether or not they are funded via central bank purchases of government bonds. It's all very well having more or less every government in the world borrowing more, but where are the creditors? Had the downswing been relatively mild, perhaps a counter-cyclical fiscal plan would have worked well. Around the world, though, we are seeing an implosion of demand on a scale not seen since the 1930s. With levels of nominal GDP collapsing, governments are short of tax revenues and long of debt. For governments unable to convince markets of the coherence of their fiscal plans, devaluation and default threaten, as they did in the 1930s.
The G20 summit, therefore, needs to do more than deliver a series of promises from individual governments, because not all promises will be achievable. Some countries, particularly in emerging Europe, have no fiscal manoeuvrability and may find themselves facing economic and fiscal collapse. What can, and should, the G20 nations be doing to limit these emerging crises?
The obvious answer is to beef-up the IMF. Gordon Brown and others are pushing for a $100bn fund to support trade credit. Meanwhile, China and others will be hoping to increase their share of the IMF's bragging rights – emerging economies are ludicrously under-represented in the IMF while some of the smaller European countries still wield clout despite their Lilliputian economic weight.
Yet there is an obvious inconsistency between the grand hopes associated with the G20 and policy decisions being made by individual nations. The catastrophic collapse in bank lending to emerging economies in recent months partly reflects the demands being placed on Western banks by their new government paymasters. Governments have to justify to taxpayers why miscreant institutions are receiving so much money: the obvious way to do so is to ensure banks lend domestically rather than elsewhere.
Many emerging economies, though, have very small domestic banking systems and are very dependent on lending provided by Western banks. Gross banking inflows into the emerging world have gone up by around $300bn since the start of the decade. A lot of those flows have dried up over the last few months, held back by what can be described as the new financial nationalism. Meanwhile, as Western economies seek to protect their ailing car industries, what happens to car factories in the emerging world which, unlike their Western counterparts, cannot easily benefit from government aid because government finances are too enfeebled?
The underlying problem is simple. Policies designed to bail out the world's banking system inevitably have a nationalistic bias. They might work for individual countries but unintentionally threaten the global financial order. The G20 meetings might go some way to solving this conundrum but, with governments answerable to constituents, there are no guarantees. Saturday's G20 protests in London took place under the banner of "jobs, justice and climate". Attempts by Western powers to safeguard jobs at home, though, may end up proving a huge injustice for countries in other parts of the world which, in recent years, have grown ever more dependent on Western bank finance.
Stephen King is managing director of economics at HSBC
stephen.king@hsbcib.com
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