Why we should have let the banks go bust
By
MoneyWeek Editor
John Stepek May 11, 2009
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Now we know why MPs were so keen to see the property bubble continue. Half of them have been flipping houses and building little property empires on the back of the taxpayer.
It's almost too good to be true. You buy a second home, then you do it up using taxpayers' money, then you sell it on for a tasty profit. But you tell the taxman that it's your main home, so that when you sell it, you get to dodge any capital gains tax.
It's the kind of loophole or tax avoidance scheme that Gordon Brown and Alistair Darling would have closed in a shot if anyone else had been doing it. But of course, you can't expect our leaders to obey the same rules as everyone else.
I won't go on about dodgy expenses here – I'm sure there are plenty more revelations to come. But what MPs have been doing is a nifty example of everything that's wrong with our current system. And no one's doing anything to address it. It's a little problem I've mentioned before – "moral hazard"...
Moral hazard caused this pile up in financial markets
The term 'moral hazard' seems to have originated in the insurance world. It's the idea that if people feel insulated from the consequences of their actions, then they will take more risk than if they had to bear the responsibility or the cost of their actions themselves.
For example, if you have car insurance, you might be less careful about locking up when you leave the car. Or if you think that no one will ever know what you've put down on your expenses form, then you might decide that it's perfectly OK to claim for a bath plug, say, or to do up and sell on properties at the expense of the taxpayer.
But moral hazard isn't limited to MPs and careless car owners. I've argued before that moral hazard is essentially what caused the current pile up in the financial markets. Central banks set interest rates too low for too long – this became known as the "Greenspan put" in the US. The big players in the financial sector knew that the good times couldn't last – that's unquestionable. But with the US central bank clearly behind them every step of the way, they gambled on the notion that they were too important to the economy to be allowed to fail, and that the authorities would do whatever it took to bail them out.
And they were right. Politicians have indeed done 'whatever it takes'. And now the banks – having been allowed to dump all their toxic assets on to the taxpayer, and fiddle their accounts – are turning profits again, which has in turn helped ignite the current bear market rally we're seeing.
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Banks are set to rely more and more on the taxpayer
But the trouble is, this bailout isn't over. The banks will have to return to the taxpayer for more and more money as the economy worsens and bad debts continue to mount. The International Monetary Fund (IMF) reckons there's at least another $1,500 billion to write off at US and European banks. As Neils C Jensen points out in The Absolute Return Letter, "it will take longer than 18 months to unwind the excesses of the past 25 years."
But by engaging in what is effectively a cover up, and accepting that the banks are too big too fail, the authorities have now ensured that they can't let any more banks go bust. That means our economy will be held back by lumbering, "zombie" banks, just as Japan's was. And it also means a lot more public money being spent. Jensen, using IMF statistics drawn from previous banking crises, reckons that the 12 most industrialised countries (including the US, UK and Japan) could need to issue a total of $33 trillion in debt to cover the costs of the crisis. And that's not even a worst-case scenario – that's based on the average rise in public debt in the three years following a banking crisis.
That's a lot of money for bond markets to absorb. It's about a third of total global savings, reckons Jensen. As he puts it, this means that one of two things may happen. "Either this crisis will ignite such a bout of deflation that investors will happily own government bonds yielding 2-3% or the deflation scare goes away ultimately, the global economy recovers and bond investors demand much higher yields for taking sovereign risk."
Neither scenario is very appealing, and "both are quite bad for equities longer term," says Jensen. As one of our Roundtable participants points out this week, it also means we could well see a spike in countries going bust in the next few years (more on this in this Friday's issue of MoneyWeek – if you're not already a subscriber, get your first three issues free here).
What could we have spent all that money on?
There's also the small case of what we could have spent all that money on. As US fund manager, GMO's Jeremy Grantham points out in his regular newsletter, if we took all the money spent on bailing out "incompetent banks" and spent it instead on "really useful, high return infrastructure and energy conservation and oil and coal replacement projects" then it would seem like "a real bargain for society."
"Yes, we would certainly have had a very painful temporary economic hit from financial and other bankruptcies if we had decided to let them go, but given the proven resilience of economies, it would still have seemed a better long-term bet."
This view is still in the minority for the moment, but it's gaining traction. And I suspect that by the time this is all over, most people will be wishing that we'd let all the failed banks go the way of Lehman Brothers.
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