We are in an era of globalisation, we are told, of flat, inter-connected worlds. Yet the response in the US Congress to the Treasury’s proposed $700 billion remedy for this very international financial crisis has been strikingly parochial.
Not just that: it has been delusional. How else to describe those Congressmen who opposed the first vote, accusing Treasury Secretary Hank Paulson of practising “financial socialism”, which was somehow “un-American”?
This episode bodes ill for the world economy’s stability. For, huge as it is, this $700 billion package is unlikely to be the end of the story. At some stage next year, the new administration, whether led by Barack Obama or John McCain, will most likely need to offer another strong dose of “socialism” – a big bag of money, this time used to help recapitalise the banks directly. Given the public anger displayed in the past week about an undeserved lifeline for the greedy bankers of Wall Street, the politics of that next package are likely to be just as poisonous.
This may seem like a strange prediction – after all, the package now on offer has been sold as a way of solving the problem once and for all. But the reason we can make this prediction with confidence is because this crisis has happened before.
Just as we have during the past decade, Japan in the 1980s enjoyed a decade of astonishing economic growth, as its property and stock markets boomed. By 1989, the property value of Tokyo alone was – in theory at least – twice that of all the land in America.
What followed when the bubble burst is now eerily familiar: long queues of depositors outside banks, withdrawing their money in a panic; a huge furore about a public bail-out of housing loan companies, which discouraged politicians from attempting a wider economic rescue package; the banks’ troubles mounting, with several going bust, leading to a soaring suicide rate.
The government was finally obliged to step in, but by then – seven years after the collapse had begun – the cost to the Japanese taxpayer had become far, far larger than it would have been had officials bitten the bullet four or five years sooner.
Is this the fate that awaits the US, along with Britain and Europe? Are we witnessing the end of the capitalism red in tooth and claw that some of us have known and loved (and others have known and hated)? Certainly not – because the Japanese example also offers us a path out of our difficulties. Japan’s was the first credit crunch, and the first deflationary spiral, to have occurred in a major industrial economy since the 1930s.
Businessmen often talk of the desirability of having “first-mover advantage”. Yet in this case, coming second is surely better. Even if American and Europe make their own mistakes now, we should, with luck and foresight, be able to avoid repeating Japan´s.
Despite all the name-calling in recent days in Congress and the US media about financial socialism, America’s housing market has long been the most socialist in the developed world. This is a country that provides massive tax subsidies for private home-ownership, and set up and nurtured two huge enterprises, Fannie Mae and Freddie Mac, which had implicit federal guarantees and a mandate that led them to back virtually half of all American mortgages.
So even though America’s problems began in the “sub-prime” sector, it was not the housing system that caused the crisis. The blame needs instead to be laid on ultra-cheap money, over-confident bankers and inadequate regulation. Those were exactly the sort of factors that brought about Japan’s financial crisis in the 1990s, the one that led to more than a decade of economic stagnation.
The trouble began in the stockmarket. Under the international banking rules, the Japanese had been allowed to count equity holdings – shares in other companies – as part of their capital. So when the Tokyo stockmarket lost a third of its value in the first half of 1990, the banks’ capital ratios – the measures of how much security they had against their various deals and investments – also came under pressure.
Despite that, the Bank of Japan was so panicked by a spike in inflation that it carried on raising interest rates until August 1990. It did begin to cut them until July 1991, a full 18 months after the market collapse commenced. Ben Bernanke, the chairman of the Federal Reserve and fully conversant with Japanese history, started to slash interest rates within a few weeks of the credit crunch.
Japan’s biggest mistake, at least with the benefit of hindsight, lay in its treatment of its banks. As their capital shrank and as their loans turned sour, the Japanese Ministry of Finance decided not to intervene, at least not with public money.
It helped banks conceal their losses by massaging their accounts, but otherwise hoped that the market would eventually sort it all out – albeit with the help of a large programme of public works, building new bridges, roads, dams and more in an effort to support growth of which John Maynard Keynes would have been proud.
It failed. The reason why it failed is that as banks’ problems mounted, they started to reduce new lending, sapping the economy’s strength. As the economy weakened, more old loans turned sour, as companies went bankrupt or just stopping paying interest. It became a slow but vicious spiral. More bad loans, more concealment of losses, less trust in the banks, leading to more defaults and to occasional runs on smaller banks.
Ironically, Japan had been infamous during its 1980s heyday as a clubby, tightly regulated place in which companies, bankers, bureaucrats and politicians were in cahoots with one another, while incomes were kept fairly equal. Lech Walesa, Poland’s anti-Communist hero, was reported to have described it after a visit as the world’s only successful example of socialism. Yet in response to the financial crisis and the crumbling of its banks, Japan responded by trying to ignore the problem, hoping it would go away.
The lesson is that once a vicious downward spiral begins in the financial system, with lending being cut and borrowers going bust, the problem will simply get bigger – unless you intervene quickly, with public money. If you don’t act, you will find yourself intervening anyway, as Japan did in 1997-98, but at a much higher cost. The result: a prolonged stagnation and government debts totalling more than 180 per cent of GDP, the highest among the world’s rich countries.
America begins with a smaller debt: around 70-80 per cent of GDP, depending on how you account for the impact of the nationalisation of Fannie Mae and Freddie Mac. In Britain and Germany, debt levels are lower – and it is not yet clear that we will need similar public bail-outs to the Paulson plan, for the build-up of bad debts in our banks has not yet reached danger point.
With America’s GDP of $14 trillion, even the $700 billion in this new package would only push debt up by four per cent more of GDP, The bad news, however, is that the cost may well rise further. In the end, Japan’s crisis, like Sweden’s earlier in the 1990s, was brought to a close only when the government agreed to pump money directly into the banks by providing fresh capital in return for shareholdings. That really will smack of socialism to many American politicians.
So how do we square the circle? There are two principles of public rescue that need to be applied. One is that the government must make sure it saves the banks but not the bankers: boards should be sacked, fraudsters punished and shareholders made to suffer. Otherwise, public support will rightly not be forthcoming, just as it hasn’t been for the $700 billion.
The second is that, in return for taking temporary shareholdings or even ownership of banks, the government must use the opportunity to force reforms in both behaviour and in regulation. Temporary socialism can then turn into a process of refreshing and re-disciplining capitalism itself. By cleaning up the banks and imposing new rules on them, governments can ensure that capitalism re-emerges in whatever new shape feels right for the market at the time, rather than according to some misguided blueprint drawn up in Whitehall or Washington.
Plenty of critics of capitalism, and especially of the process of liberalisation of trade barriers and regulatory restrictions associated with Margaret Thatcher in Britain and Ronald Reagan in America in the 1980s, would like to think that this whole episode of crisis, rescue and reform will bring about the demise of “neo-liberalism” and of the leadership role within capitalism of financial institutions and markets. Yet unless this crisis brings about massive levels of unemployment, prompting a resurgence of interest in public ownership and control, that hope is likely to be disappointed.
We know that Wall Street and the City of London, by which is meant the big investment banks, are not going to play a dominant role again in the American and British economies, for so many investment banks are either bust or discredited or both.
But that is not the same as the demise of liberalism. Banks, pension funds, insurance companies and other financial institutions are all perfectly capable of providing the liquidity, discipline and incentives necessary for a successful capitalist economy.
But they can only do this if they have the capital. That is why the American rescue was necessary and welcome, and why, in due course, European countries may have to do the same.
Bill Emmott was editor of The Economist from 1993-2006 and is the author of ´Rivals – How the Power Struggle between China, India and Japan will Shape our Next Decade’ (Penguin, £20), which is available from Telegraph Books for £18 + £1.25 p & p. To order, call 0870 428 4112 or go to books.telegraph.co.uk