Tuesday, 28 April 2009

Let it Fail, Let it Fail, Let it Fail

Sing the title of this entry to the tune of the Christmas song, 'Let it Snow' and we have a natty little anthem for the day.

I was pondering, at the beginning of all this banking fiasco, that had the Government stepped in at Northern Rock and just picked up the mortgage book and guaranteed all depositors, just what might have happened.

This was not my idea, no less an economist as Nobel Laureate, Joseph Stiglitz, suggested this some time ago. He was fixed on the fact that a contract for a Credit Default Swap or Collateralized Debt Obligation was in fact a two way contract or bargain jointly entered into by two companies fully aware of the consequences if something went wrong like part of the debt was toxic. Indeed, if they had had any sense, just prior to signing the deal they might have embarked on a bit of 'Due Diligence', that long lost phrase which went out of the window during the Enron scandal to have avoided such a calamity.

Stiglitz was of the opinion that if we had allowed the consequences of that failure to play out, only then could we have teased out what the true underlying liabilities were - not just at Northern Rock but in the entire banking system. True, many banks would have failed but he claimed that we could have used the shell of those old banks to build new ones with more secure procedures and tighter regulations to focus them on their core functions of providing credit and capital.

Further, Stiglitz asserted that the overall cost to the taxpayers would have been less in the long run as at least we would have known exactly what we were paying out for. His claim is that in the current scenario, we are propping up an already failed system, that part of the guarantees and loans that we have paid for will actually underwrite part of the 'good books' because no one is encouraged to itemise the toxic debt as it is being all paid for so why not ask for more and cover current good debt.
Sound wrong? Just look at the Enterprise Loan Guarantee Scheme from the Government meant to cover and encourage new lending - banks are taking existing loans, handing out small increments to qualify for the scheme and then getting 75% of the original debt covered. The amount of net new lending is trivial.

My view, which is with Stiglitz, is that banks should have played this all out. I dare say there would have been more sad cases like Mr. Kellerman in the US as bank executives were troubled with the terrible burdens of their greed, but I doubt it would have troubled them that much. There would have been a terrible loss of confidence in the banking system, have no doubt. That is what has been most protected in all this - banks must never fail, according to all Governments. The fact is that some banks do fail. Lehmans were left to fall and the repercussions were not that huge.

The problem we have bought for ourselves, as Stiglitz has pointed out, is that if all we do is reset the sail to catch the wind again, then all we have done is hidden the problems to manifest themselves again in the future. He now predicts we have set ourselves a course which will commit us to ever shortening cycles of peaks and terrible troughs in our economies with no chance of any kind of sustainable stability. There is no doubt that the alternative would have meant a period of recession possibly depression but we are in a different age now. No more the '30s where people could not eat, the majority would still have had some way of providing for themselves. It would have been a different kind of austerity that would have curtailed our wanton materialism - and would that have been such a bad thing? Besides, it could argued that this is exactly what we are going to get anyway.

As Stiglitz does, I think we have missed a massive opportunity to put this all right and start again, properly.

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