Why is the failure of banks and associated financial institutions a greater threat than would be the failure of other large businesses such as Ford or General Motors? There are two main reasons.
First, these institutions provide the bulk of the money supply. The readiness of individuals and businesses to spend depends on many things – income and assets of all kinds, financial and real. But money holdings are their first line of defence. If their validity is in doubt, people feel not only poorer but also anxious and disoriented. In normal times they vaguely know that banks do not have in their tills currency notes to meet a mass demand for cash from their depositors, but this is mainly an item for general knowledge quizzes. It becomes of supreme importance when the headlines are full of banks in trouble and quite serious people only half-jokingly wonder whether “under the mattress” might not be a better place to keep their immediately available savings.
Second, one can imagine a system whereby savers lent directly only to short-term business and personal borrowers. But this is not all that actually happens. Savers deposit funds that might be quickly required in banks. The latter effectively create the money they lend out. In normal times this roughly balances out through some mixture of market forces and central bank policy. But when banks are afraid to lend, these are not normal times and we risk not just recession, but depression.
The first problem is easier to tackle than the second. The Irish have led the way by their guarantee of all bank deposits as they had already led with their rejection of the totally unnecessary Lisbon treaty. This week's £400bn ($690bn, €510bn) UK programme virtually provides such guarantees. But why only “virtually”?
On the second problem there are many approaches including the state capital holdings in UK banks announced this week and, if necessary, full nationalisation. There are also all kinds of precedents, from the New Deal to Mussolini, of state agencies lending to or acquiring sound non-financial companies in temporary difficulties. These agencies persisted too long and held on to their corporate assets too long. Any human instrument can be misused.
Already there are warnings that all such devices will increase budget deficits and debt. So be it. Maxims about debt that might be prudent for families can be the height of folly for governments. Keynes in the above quotation was writing at the onset of the Great Depression. But can we not act pre-emptively? I realise that people find it psychologically difficult to take on board a crisis that calls for more spending rather than belt-tightening. We had a similar situation on a smaller scale in the US when President John F. Kennedy said: “Ask what you can do for your country” and then struggled to get a tax cut through Congress.
May I end on a personal note? Some friends and colleagues ask if I have not been guilty of trying to dethrone Keynes in favour of Friedman. Not so. On many key issues these two thinkers have been at one against the financial herd. More important: when British “Keynesians” tried to use fiscal and monetary policy without regard to inflation and tried to cure the latter by making unions agents of wage restraint and businesses agents of profit control, I parted company. Recently I supported the Bank of England's disinclination to cut rates against my own instincts when we were faced with rising inflation from energy and commodity prices. These have fallen back sharply under the influence of world recessionary forces and we cannot now wait for the slow process by which these forces work their way into consumer price indices.
The Bank's internationally co-ordinated half a percentage bank rate cut needs to be the first of many – and these must come quickly. It will probably need to be supplemented by a fiscal stimulus. Most of the academic objections to this would be overcome by a temporary indirect tax cut which the UK chancellor of the exchequer can announce any time under “regulator” powers.