Monday, September 22, 2008

Debt And Taxes... Oh, And Inflation

Charting a crisis

So once again, it's taxpayers to the rescue. The bill will be big and will have several chunky elements:

  • Debt - governments are taking on a stack of debt from floundering banks; in the US the transfer is adding hundreds of billions to taxpayer debt; here in the UK we've already got the Crock's £100bn, plus whatever implicit guarantees Brown may have given Lloyds on their takeover of HBOS; there's undoubtedly more to come; and always remember - government debt is nothing more than deferred taxation.
  • Borrowing - as our economies fall into recession (now inevitable), fiscal deficits will soar; serious forecasters are already suggesting the UK deficit could easily reach £100bn pa; if we returned to levels of borrowing seen in the early 90s recession - quite conceivable - borrowing will increase to around £120bn pa ; just for reference, the government's 2010-11 borrowing forecast currently stands at a ludicrously optimistic £32bn.
  • Inflation - we're already up to nearly 5% and the lesson of history is that heavily indebted governments default via a good dose of inflation - savers pay; of course, as things stand, the Bank of England is meant to save us from that, and somehow get inflation back down to 2%; but with the financial markets in turmoil and a recession looming, the heat is on them to be "more flexible"; they could rationalise it on the basis of anticipating a fall in future inflation... as indeed, many commentators are already proposing.

So what to do?

Head for the hills is one option. But we suspect the hills aren't big enough to accomodate us all, so we need to find some alternatives.

And despite last week's panic, the least unattractive options still involve making the banks and their shareholders sort out the mess themselves. They did the lending, they reaped the profits, and they failed to manage the risks properly. Why should taxpayers be forced to bail them out?

The answer of course - as Hank Paulson spelled out to US legislators on Friday - is that we don't want innocent bank depositors to be wiped out, and we don't want the financial system to seize up. But if it transpires that the only way of achieving that is to bail out greedy bankers when they run out of cash, then we've lost. We might as well nationalise deposit takers, and much else besides (see this blog).

Unless we come up with some more market-based solutions pdq, the left are going to walk away with this (as you can hear quite clearly from the likes of Neal Lawson and Yvette Cooper at the Labour Conference).

What we need to do is to find a way of leaving the cost and the headache with the bankers themselves. Leave them with the problem of how to work-out their dodgy debts over the long-haul. Not only is that fairer on taxpayers, but also the bankers know far more about the issues - eg "where the bodies are buried" - than any government administrator can hope to know.

A government bulk take-over of so-called toxic debt is fraught with danger for taxpayers. First, at what price do we take the debt? Not full face value, for sure. But if not there, then where? Who sets the price? Bearing in mind of course, that one major cause of the current crisis is the feeling that many banks have not written down their debt investments nearly enough yet, for the simple and scary reason they don't have enough capital to recognise the full loss. If we cram them down too much, they'll have to shut up shop.

And also what happens down the line? Taxpayers don't want to be funding the debt for ever, and it would likely get resold once the current panic has subsided. But again at what price? We could well end up with the debt being resold back to the very same bankers at a knock-down price, from which they could then make a further profit. Is that what you want?

There are some interesting alternatives being kicked around by a range of eminent economists on Martin Wolf's FT blog. One emerging theme is that instead of nationalising the toxic debt outright, we taxpayers should offer the struggling banks an equity injection. We should recapitalise them to give them a breathing space. In that way we'd leave them with the problem and cost of working out their toxic debts over time.

But wouldn't that just be pouring petrol on the flames? Wouldn't it mean we'd never see our money back?

On the second point, it might well do: if the problem debt actually has no value, we're stuffed. But then, we're no worse off than we would be if we simply nationalised the debt, as is currently proposed.

And on the first point, our equity injection would carry some stiff conditions for the banks.

To start with, it would not be straight equity, but a form of equity loan known as preferred stock. It would eventually have to be repaid, once the current difficulties had passed.

Second, any bank joining the scheme would have to agree a realistic write-down of its problem debt: we'd insist on full disclosure so as to remove the fear that banks are not fessin' up to the full extent of their problems.

Third, our equity would rank ahead of existing shareholders, and a participating bank would be banned from paying any dividends to those shareholders until we had been fully repaid.

Fourth, we could insist that a joining bank should raise matching equity funds from its existing shareholders. They couldn't rely solely on taxpayers.

And all those bank bonuses that people are so exercised about? Should we ban them?

No. Government incomes policies have always been a disaster, and it would be in our interests to retain the talent in our banks. But we'd be shareholder activists, and we'd encourage existing shareholders to get much more involved in designing longer-term incentive schemes that rewarded the realisation of value rather than the assumption of risk.

There's a lot to think about here, and thinking in a crisis is always tough. But even after last week's drama, taxpayers should not simply get bounced into nationalising the bad debts of the banking sector. There are still alternatives.


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