Monday, October 13, 2008

The invisible hand gets an intangible handout

So, we’re committing £37 billion to sort out the banking system. But if we can afford such vast amounts of money – sending the national debt through the roof – to bail out greedy bankers, why can’t we find it for schools’n’hospitals, tax cuts for Hard-Working Families, etc.?

Well, it’s doesn’t quite work like that. Let’s start with a question so basic that even I can understand it:

Why is debt bad?

Pretty easy, really: debt is bad because you have to pay it back (with interest). And what do you get for these debt repayments? Nothing. Well, nothing other than the avoidance of bailiffs and the maintenance of your credit rating. You get all the benefits of debt right at the start: you borrowed the money to buy whatever it was, and now all you’ve got left is repayment after repayment.

In the case of public debt, there are various undesirable consequences for the future. More debt can mean, other things being equal:

  • higher taxes
  • lower spending
  • higher inflation
  • slower growth
  • uglier kittens.

How does the bank bailout compare?

The government is basically acting as an investor of last resort: it has put £37 billion into recapitalising the Royal Bank of Scotland, Lloyds TSB and HBOS (the latter two soon to merge). In return, it gets around a 60% stake in RBS and 43% in Lloyds/HBOS. It will hold ‘preference shares’, meaning that payment back from the banks to the government will take priority over paying out dividends to private shareholders. These shares will eventually be sold, when the market no longer needs the confidence boost of the government safety net.

In a way, it’s the exact opposite of debt: the government commits the money up front and then hopes to get a return on it over time. But on the other hand, the government will have to issue bonds to pay for these shares, although the rate of interest it pays on these is low. More importantly, the money committed through this is not simply being spent: the £37bn is quite literally staying true to that old Brown slogan: ‘borrow to invest’.

The only way that this money would be lost in full – in the way that normal debt has to be repaid in full, with nothing in return – would be if these banks immediately collapsed, leaving no assets. Every mortgage holder would have to default, and the properties the mortgages are secured against would have to lose all their value.

That’s not going to happen. Or rather, if these big banks do all go bust then £37bn on the public finances is really going to be the least of our worries.

Certainly, a fair chunk of the debts these banks hold are dodgy – it’s the fear of unknown amounts of bad debt that has been driving the credit crunch. But the market panic of recent weeks, while making some sense given the scale of the uncertainties facing the world’s banking systems, will surely prove to be out of proportion to the amount of truly irrecoverable debt in the long term.

There’s a fair chance that the government will not just get all this money back but even make a profit. In which case kittens will be cuter than ever before.

The £37bn may well be put by the auditors onto the public debt balance sheet – and there’s a prudent logic to counting it as a liability, as this sum has now been put at risk (however small this risk might eventually prove to be) so we will theoretically stand to lose it all – but that certainly doesn’t mean that this is just more ‘normal borrowing’.

Also, there’s the money involved in nationalising Northern Rock and Bradford & Bingley. Again, the government stands legally liable for the tens of billions of mortgage debt held by these banks – and, indeed, some of this debt will be bad. But most of it won’t: the Northern Rock loan book has been shrinking since nationalisation, as borrowers happily carry on making their repayments. It’s possible there may end up being losses here, but a profit is also very possible.

None of this means, though, that there are no government debt problems; there’s a recession, of what size we know not, that has probably already started. This mean less tax revenue and more benefit spending, and it comes at a point when the government’s annual borrowing was already on the high side (although overall national debt hadn’t got that bad).

This whole episode reminds us that the invisible hand of the market sometimes needs the guiding hand of the state to help it out. (Chris puts it very well: “Markets are themselves public goods. And public goods can be under-supplied by the market.” Shuggy and Andrew are also worth a read on this.)

But the huge sums of money apparently being thrown around are not simply being given to fat-cat bankers worried where their next yacht is coming from, and the odds of taxpayers actually having to meet the bill for all of this are low. The terrifying numbers will, barring utter catastrophe, gradually melt into air. This is, as the saying goes, a hand up not a handout.


Liam Murray said...

The 'invisible hand' trope is widely misunderstood, typically on the right.

Smith was talking about local market, no producer dominance etc. He would've been appalled at the lack of regulation in financial markets over the last 10-15 years. It's a tortured corruption of his analogy but what we've seen lately isn't so much an 'invisible hand' but more a superficially anonymous hand that's actually grafted onto the arms of a very small group of extremely wealthy businessmen and their political advocates.

His Theory of Moral sentiments (published before Wealth of Nations I think) set out conditions that most uber-free marketeers would balk at...

Tom Freeman said...

Mmm, you have to wonder what Smith would make of the Institute that bears his name...

anticant said...

"The terrifying numbers will, barring utter catastrophe, gradually melt into air."

So it IS all just smoke and mirrors?

Tom Freeman said...

Hopefully, it sort of is. Tthe banks don't want all this money to use in covering their losses on £37bn of bad debts - they just want a hefty stock of capital on their books for the time being so that they can reassure everyone that whatever bad debt they are carrying won't overwhelm them.

There's something slightly crazy about this whole thing. But then, even notes and coins only have any value because we're all willing to believe that they do. I try not to think about that too hard...