A Solution to the Banking Crisis

No doubt in the U.S. this solution would be called socialism by many. It is nothing of the sort of course. Socialists call this use of state ownership to rescue failing institutions hospitalisation. The taxpayer injects cash into the corporations, banks in this case, until it is cured and begins to be profitable. After that the corporation is privatised again to make profits that go to shareholders and not to taxpayers. This is a case of socialising risk but privatising profits. Socialism involves both risk and surplus being socialised and replaces the capitalist system rather than rescuing it.

Temporary full state ownership is only solution

By Paul De Grauwe

Financial Times

October 9 2008The essence of what banks do in normal times is to borrow short and lendlong. In doing so, they transform short-term assets into long ones, therebycreating credit and liquidity. Put differently, by borrowing short andlending long, banks become less liquid, thereby making it possible for thenon-banking sector to become more liquid; that is, have assets that areshorter than their liabilities. This is essential for the non-banking sectorto run smoothly.This credit transformation model performed by banks only works if there isconfidence in the banks and, more importantly, if banks trust each other.This confidence has now evaporated and, as a result, the model fails. Thegeneralised distrust within the banking system has led to a situation wherebanks do not want to lend any more. That means that they continue to borrowshort but lend equally short; that is, acquire the most liquid assets.The result is a massive destruction of credit and liquidity in the economy.The non-banking sector cannot borrow long so as to acquire liquid assetsthat they need to run their business, because banks do not lend longanymore. This risks bringing the economy to a standstill. A depression islooming.It is important to realise that this liquidity crisis is the result of aco-ordination failure: bank A does not want to lend to bank B, notnecessarily because it fears insolvency of bank B but because it fears otherbanks will not lend to bank B, thereby creating insolvency of bank B out ofthe blue. Thus bank lending comes to a standstill because banks expect banklending to come to a standstill.How to get out of this bad equilibrium? There is only one way. Thegovernments of the big countries (US, UK, the eurozone, possibly Japan) musttake over their banking systems (or at least the significant banks).Governments are the only institutions that can solve the co-ordinationfailure at the heart of the liquidity crisis. They can do this because oncethe banks are in the hands of the state, they can be ordered to trust eachother and to lend to each other. The faster governments take these steps,the better.Government interventions have consisted of recapitalising banks. These havenot worked. The main reason is that they have been triggered by bankfailures as they pop up and, as a result, have only dealt with the symptoms.The liquidity crisis is pulling down asset prices in an indiscriminate way,thereby transforming the liquidity crisis into solvency problems ofindividual banks. The governments, then, are forced to step in and torecapitalise the bank only to find out later that when the liquidity crisisstrikes again, the capital has evaporated. The governments throw freshcapital into a black hole, where it disappears quickly.Central bank liquidity provision, although necessary, has also failed toaddress the co-ordination failure and has only made it easier for banks todispose of long assets to acquire short ones (cash). Thus central banks’liquidity provisions do not stop the massive destruction of credit andliquidity that is going on in the economy.The recent decision of the US Federal Reserve to bypass the banking systemand to lend directly to the non-banking sector by buying commercial paper isa step in the right direction. It allows companies to obtain cash byborrowing long; a service banks do not want to provide anymore. The steptaken by the Fed is insufficient, however. The Fed cannot take over all banklending operations. Only the government can do this by temporarilytransforming private banks into public ones. It can then order themanagement of these state banks to lend to each other.Such a transformation (call it a temporary nationalisation) will make itpossible to jump start the interbank market and allow the normal flow ofcredit to be activated. Nationalising the banking system is not the onlyintervention necessary. There is today a general distrust of private debt.This will force the government to substitute private debt for public debt.The Paulson plan does just that. More Paulson plans will be necessary to puta floor on the price of private debt and to prevent a meltdown.The temporary nationalisation of the banking system and the substitution ofprivate debt by public debt will allow us to reach a new equilibrium. Whenthis happens, a fundamental reform of the banking system will be necessaryin order to remain in this benign equilibrium. When this is achieved thegovernments will be able to privatise the banking system again.The writer is professor of economics at the university of Leuven and Centrefor European Policy Studies___________________________________

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