China’s key role in restoring global stability

The massive government interventions announced on both sides of the Atlantic may, just, have prevented the world’s financial system from imploding.

Alongside the largest monetary meltdown in half a century, we face collapsing consumer and business spending. These problems are closely intertwined — the financial crisis is part of the cause of the collapse in spending and the collapse in spending is now undermining financial markets — but they need separate (and yet non-conflicting) solutions.

To get a handle on these problems, start on the financial side and two big “facts” about banking and money.

First, since the emergence of modern capitalism some three centuries ago, we have seen more than 30 major financial crises — about one every 10 years. But this is an average. In the United Kingdom, it has been more than 30 years since the last banking rescue (the secondary banks in 1974). One result was a growing belief, now shattered, that banking could be left largely to the private sector.

In the US, the ideology of the unfettered market is more deep-seated.

Despite the collapse and rescue of Continental Illinois in 1984, despite the savings and loans crisis of the Eighties and despite the rescue of Long-Term Capital Management in 1998, the US clung, until the last few weeks, to the belief that the banks could largely be left alone.

Nevertheless, economic history is clear: banking systems almost always eventually over-extend themselves and have to be rescued — not just the Brits and the Americans, but the Japanese and the Latin Americans in the early Eighties and then the Scandinavians, the south Asians and the Russians in the 1990s.

Secondly, money is not like cars or cups of tea — you cannot test-drive or taste it. It depends, above all, on trust and confidence which cannot be bought or exchanged. Money is the bedrock for the whole economic system. If you are to avoid catastrophe when confidence evaporates, as it has done in the recent turmoil, the only option is for the state to underpin the core financial institutions.

These two facts are the reasons we are where we are today. Faced with meltdown, the chancellor’s dramatic actions on Monday (followed by the US and Europe) are exactly appropriate: inject liquidity into the markets, provide guarantees to the inter-bank market and, above all, inject public capital directly into the banks by the purchase of their shares. But why not also match the commitments made by others for 100% security for personal deposits? This is an area where, now that the government has acted with credibility, the greater the promise, the less the cost!

Do taxpayers in the UK and in the US need to be worried about the scale of this intervention? Hardly at all. The bank shares governments are buying at these depressed prices will almost certainly prove to be a bargain. When the Scandinavians did the same, the public purse made a gain.

Moreover, as the chief secretary to the UK Treasury, Yvette Cooper, said, the scare-mongering about the scale of government debt is based on the fallacy that this is “spending” just like buying the services of a teacher or a doctor. It is not, it is a financial investment. The talk of tax rises is also irresponsible. It causes people to be more fearful and to spend less, increasing the spiral downwards towards major recession.

That recession (or the shortage of global aggregate demand) is the elephant in the room. Its origins lie in the huge imbalances in the world economy, resulting from our credit-driven consumption in the West having filled the vast hole in demand that would otherwise have been left by high levels of Asian (especially Chinese) saving.

As the West stops spending, the only way to avoid a global recession is for the Chinese to spend more. So far there is no sign of this. Would they cooperate if asked? Not necessarily, but they hold such vast dollar reserves that they have an incentive to help stop the US economy and its currency descending into chaos. The Chinese are an essential part of the solution and it is extraordinary that the G7 or G8 groups do not include them. They should be invited immediately.

Meanwhile, the current financial crisis, its reminder of economic history and the differences between finance and the rest of the economy, make two further points imperative.

One is that every major bank has to have the state standing behind it. This has been known for ages but was forgotten in the case of Iceland. We now need international agreement that countries with a small tax base must either run banks that are commensurately small or must get their banks underwritten by international bodies such as the IMF.

The second is that financial regulation has to be approached with a completely different mindset from that for the rest of the economy. Elsewhere, competition can be a substitute for regulation. In banking, the opposite applies: the greater the competition, the greater the need for regulation and/or supervision.

The twin results — the growth and influence of China, plus a more regulated and state-financed banking system — make it inevitable that the Anglo-Saxon model of unfettered capitalism will be much diminished. What will replace it is unclear, but it may well look more like a form of state capitalism — perhaps not full-blown, but something much closer to Chinese capitalism than would have seemed conceivable just a month ago. —

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