The Great Credit Freeze

Of all the phantoms conjured from the financial depths in the past ten days, the most ghastly appeared on the dark Wednesday, 17 September, when interest on the short-term obligations of the United States government, the one-month Treasury bill, turned negative and became a penalty. Such terror had overtaken the markets that they were willing to suffer a loss on their money in the hope that, in the deep bosom of the US Treasury, some of it would be kept safe.

Yet the terror of that day was not just to do with loss: money lost, job gone, wife fled, house foreclosed, sailboat beached. It was an elemental panic, such as overran the financial markets on 19 October 1987, the day the Dow Jones Industrial Average fell 23 per cent. It was a recognition that the world is not as we have been told and that the conception of value that lies at the root of modern society is, and has always been, a fiction.

In this panic, there is no reality in the sense of actual existence to prices and Lehman Brothers Holdings can be worth $15bn on Monday and nothing at the weekend. The world is held together only by instances of agreement between two or more people. It is an education that everybody should pass through, and my generation has done so twice, in 1987 and 2008. It is as if the gods of financial markets have been reading Hegel, and learnt that "through repetition, that which at the beginning appeared as merely accidental or possible, is confirmed as a reality".

Not that governments are thinking much about Hegel. Like generals fighting their grandfathers' wars, policymakers are haunted by the Depression of the 1930s, where a crash in financial markets was transformed by selfish national policies into a collapse in world trade, and unemployed men walked in droves from Sydney to Melborne, shooting rabbits for food.

Andrew Mellon, the former investment banker who was US treasury secretary at that time, thought to break value down to a sort of puritan or moral core. He is said to have burst out to President Hoover: "Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate! It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people."

His reincarnation, Henry Paulson (also once a star investment banker), has opted instead for expediency in which pure fear cuts through all moral entanglements. He has won over the administration and some supporters in Congress to his colossal plan to take $700bn or more of bad loans on to the Federal government's books. It is the equivalent of the entire US budget for social security. In promoting his plan, Paulson said: "I am convinced that this bold approach will cost American families far less than the alternative - a continuing series of financial institution failures and frozen credit markets unable to fund economic expansion. The financial security of all Americans . . . depends on our ability to restore our financial institutions to a sound footing."

Ben Bernanke, chairman of the Federal Res erve, was crisper: "There are no atheists in foxholes and no ideologues in financial crises."

In effect, the US public will recapitalise the silly bankers at a cost of perhaps $2,000 per American adult and child, maybe much more, maybe much less. In Britain, the authorities are reluctant to wield what Paulson calls the "bazooka", trying to ensure instead that the banks continue to do business with one another. Banks, under the so-called special liquidity scheme, can shore up their creditworthiness by exchanging their questionable mortgage securities for Treasury bills, securities that carry the faith and credit of the UK, which has never failed.

Already, £100bn has been drawn and nobody knows how much more will be required for both schemes. In truth, bankers have little clue now what they have (assets) or what they owe (liabilities). AIG, the insurance group that all but bankrupted itself insuring bank loans against default, asked the US authorities at the weekend of 13-14 September for $20bn, then for $40bn and finally $85bn.

What are we to make of a banking business that must be recapitalised by the public every generation? That, like the nuclear power industry, holds a gun to the public head two or three times each lifetime? And in the intervening periods treats the public like poor relations?

In all the commentary on the crisis, certain facts have been thought too elementary for consideration, so I shall consider them. The first is this: the business of banking is not profitable (as you have been told) but miserably unprofitable. It is this unprofitability rather than the idiocy or wickedness of bankers that makes the enterprise so unstable. The arrogance of bankers, their extravagant rewards and public philanthropy, are the abstract counterparts of the massive architraves and pediments of the old bank architecture, such as the Barclays Bank headquarters in Norwich. How could they not be safe as houses?

The fundamental business of taking in money and putting it out again earns a wafer-thin interest margin and will only keep bankers in luxury if it is conducted on a colossal scale. Even the most prudent banks borrow ten times their own capital, while investment banks (who do not take deposits from the public) borrow very much more: Lehman Brothers 30 times, and even the respectable Goldman Sachs 22 times. At that extent of what is known in the US as leverage, a small fall in values wipes out the bank's capital, leaving its lenders exposed to loss, and their lenders likewise in a daisy chain of failure. Commercial banks are not well-managed institutions and investment banks (with the exception, it is said, of Goldman Sachs) are not managed, in the industrial sense, at all. An unsupervised trader can wipe out a bank's entire capital, as in 1995 at Baring Brothers, or so terrify management that they reverse his trades at fire-sale prices, as at Société Générale last February.

Even at that level of leverage, profitability is still too low and banks have sought ways to ex pand their lending through various legal and quasi-legal means. (J K Galbraith used to say that as the speculative waters subside, all manner of crimes are revealed to an astonished public view.)

In a regulatory filing, AIG made no secret that some of its credit insurance instruments were designed to help banks evade restrictions on their lending. Another tactic was to combine packets of loans into interest-bearing securities and sell them on to other investors. This allowed banks to replenish their funds and originate more loans, but at the risk of spreading the default far and wide - which is why bad debts in run-down cities in the Midwest affected investors in London, Frankfurt and Tokyo.



Too many banks

The second point follows from that. The banking system is not undercapitalised for the ordinary purposes of trade, as Paulson would have us believe, but overcapitalised to the point of obesity. A brief walk down the high street of a county town reveals that. It was the genius of the short-sellers, or bears, to recognise that there are far too many banks and bankers for the use of the public - and for this insight, like Cassandra, they are hated and shunned. Paulson wants to maintain the banking industry in its bloated condition for fear that an orderly reduction in banking will turn into a rout. We will then be plunged back into the days of the Hoover administration, when 11,000 banks closed their doors for ever and business simply stopped. Yet Paulson's attempt to maintain the banking system at the extent or level of 2005 or 2006 may not be successful.

The reason is that the run on the banks which started at Northern Rock in Newcastle in September 2007 has unfolded at a time of rising, not falling, incomes and profits. The last phase of mortgage lending in the US and UK, and also in countries such as Spain and Ireland, was never likely to be repaid even in golden days. In the ordinary rhythm of trade and business, business activity will eventually contract or already is contracting. As industrial companies fall into loss and individuals lose their jobs, debts of a more solid character than 110 per cent loan-to-value mortgages will fall into arrears. Unable to raise capital in the markets, banks will once more need public support, or will fail. The Paulson "bazooka" and the swap arrangements at the Bank of Eng land may expand to the point when they impair the credit of the nation, expressed in its currency's exchange-rate. And what of poorer or less sophisticated countries who are also unable to borrow? While all eyes have been on London and New York, the Russian stock market has halved. This is the nightmare of the 1930s where the engine of world trade simply peters out.

Yet policymakers are constrained by their ignorance of financial markets, have no ideas of their own, and must take the poacher-turned-gamekeeper Paulson at his word. In Britain, new Labour shed its ancestral scepticism of the City more comprehensively than, say, the reformed German Social Democrats. As the intoxication recedes, Labour must recall in hot flushes its excruciating naivety. Peter Mandelson's "We are intensely relaxed about people getting filthy rich" is as embarrassing as Gordon Brown's hero-worship of the US central banker, Alan Greenspan, whose stock has fallen faster than Lehman Brothers common.

Yet if the financial chaos spreads out into the tangible world of job centres and shuttered factories and empty office blocks - a world where men and women, unlike bankers, must live with the consequences of their folly - politicians will demand their pound of flesh. In the US, both presidential candidates Barack Obama and John McCain are mining a popular hatred of the East Coast money men that goes back deep into the 19th century. They will place restrictions on bank lending and securities underwriting just at the point where there is no lending or underwriting of securities. Bowing to the winds of change, both Goldman Sachs and Morgan Stanley have abandoned their privileged position as investment banks and submitted to regulation by the Federal Reserve, right there alongside First Farmers & Merchants of South Succotash with its 600 checking accounts.

William McChesney Martin, the Federal Reserve chairman in the 1950s and 1960s, used to say that the job of the central banker is "to take away the punch bowl just as the party gets going". Greenspan, who at two decades at the Federal Reserve accommodated the banks in all they required, conspicuously failed to do so. In these circumstances, there will be a call for returning central banks to political control. Margaret Thatcher always opposed independence of the Bank of England, because it seemed to her an admission of political failure. She also doubted - and even her enemies would not disagree - "whether we had people of the right calibre to run such an institution". These central banks, once returned to political control, will find it hard to resist a little inflation to lighten the burden of public and private debt.

The melancholy aspect of the crisis lies not in the humbling of proud men such as Dick Fuld of Lehman Brothers or Greenspan himself, but in our ignorance. An entire epoch of finance passes in which we lived, but did not understand. Truly, as Hegel said, philosophy comes too late to teach the world how it should be, and Minerva's owl begins her flight into gathering darkness.

James Buchan is the author of "Frozen Desire: an Inquiry into the Meaning of Money" (1997)