Thursday 25 September 2008

Central bankers: have they killed capitalism?

Over at MoneyWeek John Stepek looks at the current financial crisis and asks Is this the death of capitalism?

One important question he asks is Who's really to blame for this crisis? The short answer, in his view, is central banks. He writes,
This crisis has its roots in the actions of central banks. I think it's important to make this point very clear right now. George Bush might say there'll be plenty of time for "blame-storming" later. But funnily enough, once 'later' comes around, no one can quite remember who really was to blame, and the government ends up getting to point the finger at whoever it likes – usually the media
Stepek argues that the central bankers should have popped the property bubble before it grew too big. But they didn't.
There was a rampant property bubble. The world's central bankers should have popped it before it grew too big. They didn't (although Mervyn King clearly thought that it would have been a good idea), mainly because Alan Greenspan put his hands over his eyes and said he couldn't see any bubble. He also added that, even if there was one, it would be better to clear up the mess after it had popped. It was obviously nonsense at the time, and by now hopefully everyone realises that.

Because instead of pricking it at a time when the fallout was manageable, we let it grow until harsh reality finally had to step in. Things grew so crazy that the long-term unemployed in the US were being given hundreds of thousands of dollars to buy homes on which they didn't make a single payment. This bubble stopped growing simply because it ran out of room. It just couldn't get any bigger.

Some of you might think it's too simplistic to blame central banks. But think about it for a minute. The first instinctive call of every columnist, estate agent, and business leader in the land, as they realised recession was coming, was to scream for a rate cut. That's a dramatic display of faith in the idea that whatever the problem, a quick wave of the Bank of England's magic wand would make it go away. Even now, some are still labouring under this misapprehension, even though the Fed has amply demonstrated that even slashing rates by more than half has done nothing to ease this crisis.

Because everyone thought that central banks would always be willing and able to save the economy – and the financial services industry – lenders thought they could get away with murder. All the risk ultimately lay with the government, after all. And if you take away the risk, people then do whatever they like without fear of consequences – particularly if regulators have adopted an otherwise hands-off approach.
The next question to ask is What is the solution to this?
Ideally, I'd say just ditch central banks and let the market set interest rates. Central banks, regardless of how ostensibly independent they are, are instruments of the government. The government wants happy voters, and free money makes people happy. So there's always the temptation to keep the money flowing freely.

The market on the other hand, couldn't care less what voters think. One feature of the credit boom is that most people in the City and on Wall Street knew it couldn't last forever, and they had a hunch it would blow up in a very unpleasant way. But they couldn't stop playing along, because they had to compete with their peers. However, if markets set interest rates rather than governments, then arguably this mood of rising concern among the participants, would be reflected in the price of money long before things got out of hand. Anyone who had overplayed their hands would run into trouble long before they became "too big to fail".
What is the alternative to the market?
The alternative is that we decide that banking is such a vital part of our infrastructure, that it cannot be left to the market. And if it really is the case that "banking is too important to be left to the bankers," as Roger Bootle argues in today's Telegraph, then there's no choice. We have to turn it into a utility. And just like with the water and power regulators, we need a big domineering regulator, who tells them how much profit they can make and how much they can charge us, and in return we get a government-backed banking system.
But what is likely to happen? One would suspect that by the end of all of this, we'll end up with some half-hearted mish-mash which will do little more than simply sow the seeds for the next crisis.

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