Finance and economics: what we have learned, and what still needs to be done – part 1

This week Liberal Democrat Voice is running a series of articles from Tim Leunig about the economy – how we got here and what we should do next.

Bank bailouts

The economic downturn was precipitated by financial problems. This is a sign of a successful financial sector: they are there to bear risks other people do not want to bear, and are correspondingly prone to crises from time to time. Since the underlying rationale of a bank is to borrow short and lend long, the threat of bank runs will always be with us.

Banks in Britain needed government assistance to distinctive reasons. Some banks, such as Northern Rock, lent imprudently. Their shareholders should receive nothing. This will encourage shareholders in other firms to monitor management more closely, and will reduce the bill to taxpayers. The government should close down Northern Rock as quickly as possible: Britain has lots of banks and losing one that behaved so badly would be a good thing. Better monitoring of management by shareholders, or better regulation, should prevent another North Rock.

Other banks had liquidity problems caused by relying on interbank lending rather than retail deposits. These banks made sensible loans, and both management and shareholders can consider themselves unlucky. But luck is part of business and if you don’t want to take the risk don’t buy shares. Only government was large enough to underwrite these banks’ refinancing and rightly drove a hard bargain. These banks should and will survive, and taxpayers are likely to get a reasonable return for their investment: the underlying loan portfolio is good.

In essence, bank “bail out” policies were successful: no retail depositor lost their money, runs on banks were stopped pretty quickly, and a 12% return for taxpayers on preference shares looks like a pretty good deal.

The only blot on the government’s copybook is suspending competition law to allow Lloyds and Halifax Bank of Scotland to merge. When banks are too big to fail they can take gambles without worrying about the consequences. This merger should be stopped, and undone later if it is not stopped now.

Read more by or more about .
This entry was posted in Op-eds.
Advert

9 Comments

  • The higher taxes now or later that will be required to pay for keeping Northern Rock jobs safe in Labour seats will be mean many other thousands of people lose their jobs as the increases push marginal businesses into bankrupcy.

    There is no such thing as an industrial policy that protects jobs in a failing business. Only policies that allow governments to spread the pain from areas they consider politically important to ones they do not.

  • Neil Berry is essentially correct: protecting NR jobs is costly, and that money could be used elsewhere. It is very unlikely that the money used to support NR creates any net employment.

    Note also that a cost of keeping NR open is that it continues to attract deposits, which means fewer deposits for other banks, which means other banks need more support…

  • Mark Williams 24th Nov '08 - 6:06pm

    There is still a problem with the banking sector because there are still probable undeclared losses in every bank and hence a reluctance to lend interbank. The common approach in the US with bank failures is to move the suspect assets into a bad bank to be liwuidated, leaving much smaller banks in placen to carry on the normal business of taking deposits and lending in the knowledge that the remains of those banks should be viable.

  • David Evans 27th Nov '08 - 8:30pm

    Tim,

    I like your style and willingness to confront economic issues, a deeply unfashionable trait in a Lib Dem, but I fear you may have been in the economic mainstream too long. Here is my re-write of your piece, using the rail industry as a simile to show how the parallel world of economic theory has become much too detached form the real world for my liking. My inserts are in bold, unfortunately I couldn’t get strikethrough to work on the bits it was replacing, but I hope it is clear enough.

    The train crashes were precipitated by excess speed. This is a sign of a successful railway industry: they are there to transport people safely by bearing risks of driver error other people do not want to bear, and are correspondingly prone to massive crashes from time to time. Since the underlying rationale of a railway is to reduce driver error by reducing the number of drivers and agglomerating lots of individual journeys into one large vehicle, the threat of massive train crashes will always be with us.

    Railway companies needed government assistance to distinctive reasons. Some railway companies, such as Northern Rock, drive their trains imprudently. Their shareholders should receive nothing. This will encourage shareholders in other firms to monitor management more closely, and will reduce the bill to taxpayers. The government should close down Northern Rock as quickly as possible: Britain has lots of railway companies and losing one that behaved so badly would be a good thing. Better monitoring of management by shareholders, or better regulation, should prevent another train crash.

    Other railway companies had engineering problems caused by relying on shared infrastructure that was not being maintained as well as it used to be rather than using its own engineers. These railway companies made sensible journeys, and both management and shareholders can consider themselves unlucky. But luck is part of business and if you don’t want to take the risk don’t run trains. Only government was large enough to take over the failing infrastructure and failed to drive a hard bargain and left the old management who were too busy claiming their bonuses to notice that the track was deteriorating, still in charge. These railway directors don’t deserve to survive, and taxpayers are likely to get a pitiful return for their investment: the underlying management remains poor.

    In essence, bank “bail out” policies were successful: no rail traveller lost their money mind you quite a few were wiped out in a crash, train crashes were stopped pretty quickly, and a 12% return for taxpayers on preference shares looks like a pretty good deal if you believe the railway companies can afford such a rate of interest in a depression.

    We wouldn’t accept this sort of excuse for railways. Why are banks and bankers treated so well in their incompetence?

    David

  • Sorry Tim,

    I missed out one section in the above.

    The railway companies also invested heavily in a new virtual train the “Structured Investment Vehicle” or SIV which allowed railway companies to apparently run more trains and let them travel much closer together, while offloading the risk to insurance companies who did not understand the real risks in the design. Consequently the railway companies began to make bigger profits from the virtual journeys than they did from real journeys and their focus changed from running a real train service for the benefit of the public, to running a train service solely to be able to make and sell on SIVs to other train companies. Indeed some railway companies only ran SIV train services.

    Railway companies thought SIVs were a cornucopia of profits as when a real passenger were passed form one SIV to another, both companies made bigger virtual profits than either did if they carried the passenger all the way. Unfortunately, what the train companies did not notice was that SIVs became increasingly unstable when in close proximity to other SIVs, until the period of the great crash when one by one SIVs came of the rails and the entire rail network ground to a halt. Now railway companies refuse to accept that other companies SIVs can be safe, but still have absolute confidence in their own. However, having spent and lost (or invested in economist speak) billions of pounds in them, they have them stuck in sidings as no one will let them pass and no one has the money to buy them and make them safe.

    Now only real trains are allowed on the network, but because the train companies lost so much money they can’t afford to run as many as the public need and as they think journeys are more risky the costs have increased massively for members of the public who have still to complete their journey to their ultimate destination at the end of the line, the station known as Mortgage Redemption.

  • David,

    I have only just seen this – apologies for not responding earlier. Safety systems on trains are the equivalent of financial markets, not trains themselves. They are there to protect us from inevitable risk. They are not perfect, and sometimes people get hurt.

    Financial markets take on risks that people don’t want to hold. That is why Woolworth’s shareholders lose their money – so that the rest of us don’t have to.

    It isn’t perfect – the equity cushion was inadequate in the case of NR, B&B, Lloyds and HalifaxBOS, RBS, and therefore the state stepped in (just as it would, incidently, if a rail co went bust – that is in the legislation). Hopefully and I think plausibly the state will make money on its preference shares @ 12%, although it pretty clearly won’t make money on NR and B&B.

    We shall see. Thank you for your comments about my willingness to think about economics – as anyone who knows me will know, I think about little else 🙂

  • David Evans 3rd Dec '08 - 4:50pm

    Tim,

    Thanks for your response. However, I don’t see the significance of your “Safety systems on trains are the equivalent of financial markets, not trains themselves” statement. I was drawing attention to the absurd way financiers (and economists?) still rationalise the favourable way they look at banking, compared to what most people would consider the real world. Putting it bluntly, banking and the finance sector in London messed up big style and have gambled and lost this country probably as much as they have contributed over the last 20 years. It is not a success. It is an abject failure.

    My worry is if we as Liberals do not understand this failure and plan from that basis, we will not learn the correct lessons and we will not make the correct policy decisions. Labour would never consider or allow this sort of analysis of the failure as it formed the basis for Brown’s economic miracle. Likewise the Conservatives won’t, because too much of their funding comes from the mega rich. I really do believe we as a party are the only hope in this matter and if we allow ourselves to follow your logic in this area and pretend a failure is a success, we will add nothing of value whatsoever.

    All the best,

    David

Post a Comment

Lib Dem Voice welcomes comments from everyone but we ask you to be polite, to be on topic and to be who you say you are. You can read our comments policy in full here. Please respect it and all readers of the site.

To have your photo next to your comment please signup your email address with Gravatar.

Your email is never published. Required fields are marked *

*
*
Please complete the name of this site, Liberal Democrat ...?

Advert



Recent Comments

  • Peter Hirst
    The Conservative leadership contest is easy to criticise. What should replace it? A definite GE following it would help it gain some legitimacy. The present gov...
  • Graham Jeffs
    "There isn’t an easy solution, but naming the problem is a start." Absolutely right! But is there any evidence that our party is actually going to do that?...
  • Julian Tisi
    The problem is bigger. Under our constitution, none of us vote for the PM directly, but instead the PM is selected from Parliament whom we elect directly. Thu...
  • Simon McGrath
    This is an odd post. If Jo Swinson had won the last election and had to stand down for some reason , a rather smaller number of LD members would be choosing th...
  • Tom Harney
    Where is the public outcry? If there is to be a public outcry then someone has to lead it. That should be the leader of the opposition. Why are his party not de...