Andreas Whittam Smith: In a financial crisis, the public trusts no one

The good news is that markets can heal themselves. But it takes time

There have been two bank runs since the crash of '07 this summer. The first took place in the secrecy of the money markets some weeks before Northern Rock found depositors queuing outside its branches to ask for their money back. The two bank runs had the same characteristics.

A bank run begins when depositors no longer trust the managers of the institutions to whom they have lent money. Reflect on the banking term "credit". It is derived from the Latin verb "credo", which means "I believe" or "I trust". Nobody believed or trusted any longer

The scene of the first run, the money markets, is where banks borrow from each other and where industrial companies, and companies whose assets consist entirely of securities, issue what is known as "commercial paper", a type of IOU which is repayable within a period stretching from a few days to a month or two. These markets have no national boundaries. They are so large that their size is commonly measured in trillions. They facilitate the channelling of surplus liquidity to where there are shortages.

The earlier bank run began soon after 2 August when a small German bank announced that it was in trouble because of its investment in US sub-prime mortgages (loans to home buyers with poor credit ratings). Then a few days later, the large French bank BNP Paribas said that it had three funds with similar problems. That was enough. Suddenly bankers and professional investors everywhere were alerted to the fact that losses on subprime lending were much more severe than realised. They immediately lost their trust in a range of financial institutions. For packages of sub-prime loans had been widely distributed. Lenders refused to make further cash available to what they fearfully considered to be suspect entities and withdrew their existing deposits as fast as they could.

Northern Rock was an innocent victim in this. It did not, as it turns out, have any sub-prime loans on its books. That must have been a factor in its successful negotiation of emergency support from the Bank of England. The rule for the Bank in such a situation was laid down 150 years ago by Walter Bagehot, the great editor of The Economist: lend freely on good collateral at penalty rates. This done, though, the last thing that anybody envisaged happening was that members of the public would stage a second run after the help had been given. What does this tell us?

Go back to the Latin word "credo". The queues outside Northern Rock showed that in a financial crisis today the general public trusts neither the Bank of England, nor its Governor, nor the Chancellor of the Exchequer, nor the Government, nor the authorities in any shape or form. Note that the Northern Rock run began in the very same week that Gordon Brown, denied his past and praised Mrs Thatcher to the heavens. People must once again have thought that you simply cannot believe a word these politicians say. So when the Chancellor tells me that my money is safe, that suggests I had better go straight round to the bank and get it out.

What we have, then, is an old-fashioned panic. Governments thought they had banished financial panics for ever. For immediately after the Second World War, under the influence of Keynes, they had begun to manage their economies actively. They used as instruments the setting of interest rates, the management of public expenditure, the raising of taxes and the regulation of the financial markets and their participants. And they had become increasingly successful at this task. The swings in economic activity and inflation have declined substantially in most industrial countries since the mid-1980s, a phenomenon known as the "great moderation".

A financial panic, common throughout the 19th century and early 20th century, is a spontaneous tightening of credit brought about by fear. It is a credit squeeze engineered not by governments deliberately as an act of policy, but by the financial institutions themselves in a fit of belated and excessive prudence.

Fortunately, the financial markets are self-correcting. This is the good news. They can, so to speak, heal themselves, albeit slowly. In the first place, the world's major banks are in good shape. They are well capitalised. But they have recently been in the habit of conducting part of their activities through entities that they sponsor rather than control, that are legally independent of them rather than listed on their balance sheets. And many of these vehicles have suffered exactly the same problems as Northern Rock. They have lost the support of the money markets. However, the major banks can take these semi-autonomous units back in house and finance them from their own resources.

Moreover, the funds that have been withdrawn from what have suddenly been classified as risky enterprises do have to be placed somewhere. Some will turn up as deposits with major banks. That itself strengthens the system. Some will be invested in what are still considered to be safe securities such as bonds issued by big corporations. In addition, there has always been a market in what is known as "distressed debt". Certain big investors specialise in buying troubled loans from banks at a discount with the hope that a patient approach will pay off. And the private sector can organise rescue packages perfectly well itself.

The bad news is that this process of re-establishing equilibrium has a disagreeable consequence and will take time. More than a handful of the smaller financial institutions, whether imprudent lenders, badly run hedge funds or over-borrowed property funds, will go bust. And perhaps the small won't be so small. Had Northern Rock's lending to home buyers been imprudent, as it might have been, specialising as it did in first time purchasers, would the Bank of England have bailed it out? I believe not.

As to timing, Rodrigo de Rato, the managing director of the International Monetary Fund, said recently that the credit squeeze was a "serious crisis" that was still unfolding with a high degree of uncertainty. And Hank Paulson, the US Treasury Secretary, commented last week that "the crisis of confidence in credit markets is likely to last longer than previous financial shocks of the past two decades".

In short, this isn't going to be over in a hurry. We can only wait to see how the wider economy will be affected. The transmission belt is the housing market. Already, house prices on both sides of the Atlantic are beginning to edge downwards. In time, this will suggest to consumers that they have less wealth than they thought. It will also restrict their chances of arranging top-up loans to finance additional expenditure. As a result, the likelihood of a recession is higher than it was before the bank runs began.