Jeremy Warner: A manifesto to save the free market


The need for action



The Independent's Business and City Editor sets out a 10-point plan to defeat the credit crunch and preserve our economic system for future generations in the face of this global meltdown


Thursday, 5 February 2009

As is now all too apparent, we are in the midst of the most extreme economic event of our lifetimes. Already, the crisis is turning comfortable, self satisfied and consensual Western ways of looking at the world on their heads. Yet if policy makers, business leaders and financiers move with urgency to adopt the right solutions, there is still time to prevent the financial meltdown from turning into an equally disastrous social and political catastrophe.


Without swift and co-ordinated action across nations, there is every chance of already rising resentment among the ever-swelling ranks of the unemployed spilling over into popular unrest, threatening the very existence of "open access" societies.

Preserving the basic principles of the free market system must be the paramount purpose of policy around the globe, even though unfettered markets would seem manifestly to have failed us. Without such freedoms, societies become dominated by corrupt political and economic elites, excluding the less fortunate and depriving economies of their creativity and ability to innovate.

The risk of a severe backlash against free market policies, with creeping trade, financial and labour market protectionism, is now obvious. Lax regulation allowed financial markets to run amok, and anti-capitalist sentiment is now rising fast across the globe. Yet it is not the free market system as such that failed. Rather it lost its sense of social and ethical purpose, became corrupted, and therefore also became unsafe and unfair.

In every crisis there is opportunity. The severity of the credit crunch has given policy makers a unique mandate for action on an international scale. Even a year ago, the opportunity now presented for cooperation and financial reform would not have been thought remotely possible. Next April's meeting of the G20 in London provides a ready-made springboard for such action. It is vital that it be seized with both hands.

The world is sinking fast into a vicious downward spiral of collapsing credit and demand, with rising unemployment. So grim has the picture become that it is no longer clear which is cause and which is effect. The following 10 point manifesto is therefore directed both at crisis resolution and at long-term reform. Some of the initiatives are aimed at mitigating the immediate crisis. Others are directed solely at the policy response here in the UK, while still others have international relevance.

Remedies are also suggested for shoring up the system, for reforming and rebooting it, so that future financial and economic crises of this magnitude are averted and free markets are preserved for future generations.

1. Start fire-fighting

Paradoxically, addressing the crisis involves the same poison that created it in the first place – excessive debt. As governments around the world seek to bail-out their banking systems and revive their economies with fiscal stimuli, they are only replacing one form of debt with another. Public debt is substituting for the private debt which is no longer available. Credit risk is thereby being socialised on a hitherto undreamt of scale, leaving future generations of taxpayers with potentially crippling liabilities.

Though obviously undesirable, this is for the time being a wholly necessary response to the crisis without which the banking system would collapse and a classic deflationary spiral of rapidly rising unemployment would soon establish itself. Even as the banks draw in their horns and reduce the availability of credit, the state must stand ready to act as alternative lender of last resort. Previously unacceptable levels of public debt therefore become inevitable and may be part of the cure.

2. Restore sound money

To win credibility in markets, governments must set out a clear road map for restoring balanced budgets and reducing public debt over the medium term. Without this plan, it may not be possible for governments to borrow on the scale necessary to see economies through the crisis. Markets could as easily lose confidence in the ability of governments to repay their debts as they have done with banks.

Nations that lose the confidence of markets will be forced to pay penalty interest rates, further adding to the costs of supporting their economies. Any attempt at "quantitative easing" – the technical term for printing money as a way of funding these newly acquired, public liabilities – should be used with the utmost caution.

Historical precedent points to the potentially calamitous inflationary consequences of debasing the coinage in this way. The return of inflation may seem the least of our worries right now, or even mildly desirable, but there is no point in simply replacing one problem with another. Inflation is as much an enemy of sustainable growth as deflation. Return to the principles of sound money will eventually require steep rises in taxation and cuts in public spending. Just as growth in government spending shares responsibility for the crisis with the bubble in credit, the public sector must help shoulder the pain of the correction. Real cuts in public sector wages and pension entitlements will have to be pushed through to match those the markets are imposing on the private sector.

3. Nationalise the banks

Outright nationalisation of a number of domestic banks may be the only way to get them to resume their proper role of transforming short-term deposits into long term loans for enterprise and households. Not all countries will have to do this, but in the US and the UK, we are halfway there already.

There is a certain inevitability about the likely end game of full-scale public ownership. Nationalisation is an emotive word, encouraging the idea of a return to socialism and state control. This would not be the purpose of public ownership of the banks. Rather it would be to enable a clean, swift and effective way of restructuring the banks so that their bad assets could be removed into a long-term workout fund, and the "good bank", in which depositors and the money markets could have renewed confidence, could then be refloated on the stock market.

In nationalising, governments must therefore commit to a clear timetable for re-privatisation. As things stand, there is no confidence in bank balance sheets. Government initiatives to recapitalise the banks, underwrite their bad debts and provide them with liquidity support may have saved them from outright collapse, but have failed to restart the process of credit creation. Furthermore, any increase in domestic lending that the banks have achieved seems to have been at the expense of lending to emerging and other overseas markets.

The process of balance-sheet reduction is unrelenting. Only by nationalising the banks outright and funding vital domestic lending directly from the public purse can governments properly address the viciously negative effect of bank "deleveraging".

The "good bank" that emerges from the public sector restructuring would have the balance sheet strength to lend and borrow in the normal way. Yet there is no getting away from the fact that a crisis caused by an excess of credit can only ultimately be addressed by removing the debt overhang. Virtually all developed nations are overleveraged, with public and private debt combined representing a significant multiple of GDP. The consequences of reducing this overhang slowly are likely to be less severe than the chaos of a disorderly unwind, yet however it is done, there is no way of avoiding the pain altogether.

4. Complete Doha

Protectionism is once more on the march, threatening an internationally destabilising rush to "beggar thy neighbour" tariffs, bungs, subsidy, soft loans and trade restrictions. From steel tariffs in India to the "Buy American" attributes of the Obama fiscal stimulus, measures aimed at protecting local jobs and industries are mushrooming. In this crisis, there is also the emergence of a new form of protectionism, where governments seek to funnel scarce credit to their own home markets at the expense of the developing world and other foreign debtors.

Some countries already see protectionism as the medicine. In fact it is the poison which will stifle all hope of swift recovery. With recessionary forces now biting hard the world over, there could scarcely be a more difficult time to complete a further round of trade liberalisation. Yet nor could it be more necessary. The deal is almost done. All that is required is the political will among a small number of recalcitrant nations – chiefly the US, Brazil, India and France – to push it through, thus reaffirming international commitment to free trade and the arbitrating powers of the World Trade Organisation.

Without free trade, political extremism and international conflict becomes almost inevitable. Yet we also have to be realistic, and to acknowledge that extraordinary times call for extraordinary measures. It's entirely reasonable for nations to want to support their key strategic industries through the storm with subsidy, soft loans and other forms of government assistance. The temporary suspension of such rules therefore looks justified provided it is done according to an internationally agreed framework with a firm commitment to their reintroduction as soon as economic conditions improve. Otherwise all the hard won achievements of the single European market and other free trade areas will be thrown away.

5. Introduce counter-cyclical measures

Governments must move swiftly to reform the Basel capital requirements, which encourage banks to lend recklessly during the good times but to wrench the gears into reverse during the bad. The same is true of "fair value accounting", which similarly encourages banks to expand their balance sheets during the boom but shrink them during the bust. Thus does originally well-intentioned regulatory reform frequently give rise to perversely adverse outcomes. A "B20" of business leaders and bankers might be formed to guard against the dangers of over-reaction and the law of unintended consequences in the reform agenda.

Banks are not just at the heart of the business cycle, they also magnify it and may in the way they turn the credit taps on and off be its predominant cause. These pro-cyclical attributes of the banking system must be addressed with urgency. Bankers make convenient scapegoats, but years of easy money and lax regulation, deliberately encouraged by the politicians because it created the illusion of prosperity, was the backdrop against which banks lost the plot. Governments, regulators and central bankers must take their share of the blame. In addressing the failings of bankers, the G20 must address all the embedded pro-cyclicality of the system, even where it involves interfering with the politics of the ballot box. Central bankers must be made to target the growth in credit and asset prices, as much as inflation in the price of goods.

6. Reduce capital imbalances

Governments are also to blame for ignoring the dangers of global trade and capital imbalances, under which the consumerism of the West was financed by the savings and capital surpluses of the developing world and the oil-rich nations of the Middle East. In essence, the Chinese and the rest of the developing world have been lending us the money to buy their goods. For years, economists have been saying it's unsustainable. Yet in time it became the new norm and it ended up fuelling the biggest credit bubble the world has ever seen. It is not just the deficit nations that must now pay the price. The big surplus nations must accept that they have responsibilities too and must take greater steps to stimulate domestic demand. A free-floating Chinese exchange rate would be a good place to start.

7. Enforce corporate responsibility

Something very precious was lost during the boom, when banking and business became more about individual enrichment than serving the interests of the client. Providing it was legal and you could get away with it, almost anything went. Complexity in financial markets came to be used as a form of concealment, or even deception. Wall Street and City bankers behaved like the snakeoil salesmen of 19th-century America. The fundamental purpose of finance became forgotten in the rush to personal, short-term gain – that the markets are there to serve the wider economy and the wider economy is there to serve society as a whole.

A statutory code of conduct may have to be introduced to ensure generally accepted ethical values are injected back into the system, and to encourage long-term thinking in investment decision making. Bankers should be forced to take something similar to a Hippocratic oath. Alternatively, they could be made personally liable for failings within their institutions, leading to confiscation of their ill-gotten gains when things go wrong. Many bankers have so far lost their jobs, but they have yet to pay any penalty in terms of personal assets. Personal liability would increase the sense of partnership with other stakeholders, as well as discourage excessive risk taking.

8. Retribution

Justice demands that bankers whose excesses have helped bring the system to its knees are punished. They may not have done anything overtly illegal, though there is plenty of evidence of deception and false accounting. But there will be no closure on this crisis, or end to the growing sense of public injustice, until those responsible are subjected to the full force of public and criminal inquiry. The careless way in which the crisis is dismissed as an inevitable part of the cycle is entirely unsatisfactory and only encourages the view of one rule for the poor and another for the rich. Some bankers need to be made an example of. An eye for an eye.

9. Don't forget climate change

The climate and credit crises have much in common. Both have their origins in the idea that it is perfectly acceptable to pump up the system with huge amounts of toxic material – in the case of the credit crunch, trillions of dollars of sub-prime lending, and with climate change, millions of tons of carbon. The consumerism of the credit bubble has moreover fed the growth in emissions. Both were based on unsustainable assumptions. Success in Copenhagen would send out a powerful message of international co-operation. But to succeed, the developed nations must be humble before the reasonable aspirations of the developing world. Developing nations cannot be frogmarched by the West into a low-carbon future but helped and nurtured into it.

10. Reform international institutions

There needs to be a complete overhaul of the international organisations responsible for enacting all of the above, from the International Monetary Fund to the Financial Stability Forum and the international accountancy bodies. We'll never get global regulation of banking – or not until there is a global currency, central bank and fiscal organisation – if only because as things stand individual nations must use their own taxpayers' money to underwrite their banking systems, and are therefore highly unlikely to cede prudential supervision to a non sovereign regulator. But a treaty-based organisation such as the World Trade Organisation, with powers of enforcement on internationally agreed standards, is a reasonable aspiration.

Jeremy Warner has been Business and City Editor of 'The Independent' since 1995