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Amid all the panic, there is some good news claims Hamish McRae

8th October 2008

If you can keep your head when all about you... you clearly don't appreciate the gravity of the situation. The market panic - and that is what it is - that has stemmed from the loss of faith in the global banking industry will eventually subside. All the long history of past financial panics demonstrates that. The issue is the amount of damage on the way.

We cannot begin to see the details of the outcome of the events of the past three or four weeks. We do know that the initial efforts by the world's monetary authorities to reassert control over the banking markets, and thereby restore confidence in them, have failed. So they have to go on, and on and on.

Alistair Darling has taken some stick for saying that the government will do whatever is necessary to restore confidence and its performance, and that of the Bank of England, has not been optimal. They underestimated the scale of the pressure on the banks, and how it would mount, but they were in good company.

In any case it is very hard to do these things well. At least the UK or European authorities have not made a mistake on the scale of their counterparts in the US, where the failure to support Lehman Brothers provoked this present element of the global meltdown.

The word is "systemic" - when the failure to support one institution leads to a breakdown of the entire system. It is a textbook example of what central bankers and finance ministries fear most and all past experience shows that if the authorities fail to do enough early on they have to do vastly more later.

They have two weapons, two things that only the state can do. They can create money and therefore ease liquidity concerns; and they can invest funds in institutions, backed by the taxing power of the state.

The first is now happening on a huge scale. As long as banks can give the central bank some kind of asset, such as a parcel of loans to customers, and exchange it for cash, banks can keep going. If you believe, as I think most of us do, that the vast majority of British people will be able to go on servicing their mortgages, then the home loans the banks swap for cash at the Bank of England will not involve any loss to the Bank or ultimately the taxpayer.

The Bank can and will cut interest rates, which will make things easier for borrowers and for the commercial banks themselves. And there is virtually no theoretical limit to the amount of money a central bank can create, though as Zimbabwe has discovered, you may have other costs if you create too much of the stuff.

So central banks around the world will continue to flood the markets with money. They have no option but to do so, and they will go on and on until banking confidence returns.

The second thing that only the state can do is to back investment with its taxing power. If the problem of the banks, or bank, is not only one of liquidity but one of solvency, then recapitalising it costs real money. If those mortgages the banks swap for cash at the central bank really prove to be duds, then someone has to pick up the tab and that has to be the bank than made the swap. If it does not have to capital to do so, then it cannot continue. It has a solvency problem not a liquidity one, though in practice the two often run together.

What happens then depends on the importance of the bank. It is the systemic thing. When it was Barings it was let go and there was no general breakdown of confidence. With Lehman there was. Where we are now is that states around the world, including Britain, are putting or will have to put taxpayers' money into their banks – in some form or other.

They will rightly want something in return, but they still have to do it whether they like it or not. That is because alongside the danger of a systemic breakdown, there is an implicit guarantee of all deposits in major banks in the developed world. That has been made explicit up to a limit, in the UK of £50,000, but actually it is unlimited. In Ireland, Greece, and it seems at least for retail deposits in Germany that guarantee has been made explicit but in reality it is there elsewhere. So in return taxpayers will need some share in the rewards, as well as the pain. Just how that is done is in a way less important than that it has to be done somehow.

If all this seems rather daunting, at least for us as taxpayers, there is some good news here. It is that the numbers involved are well within the financial capacity of the modern state. Take Ireland. Much was made of the fact that it was guaranteeing deposits worth twice the national income. But even in the worst possible case not all that would be lost. Say 20 per cent was lost; all that would do on my back-of-an-envelope calculation, would be to push Ireland's national debt up to about 75 per cent of GDP, which is pretty much the European average.

Even if in a most extreme case, the UK taxpayer had to invest £250 billion to recapitalise British banks, five times the number now being discussed, that would push up our national debt to GDP ratio to about 60 per cent of GDP. And of course there would be assets against those liabilities, assets that might be sold at a profit some years on. To put this into perspective, at the end of the Second World War, the UK's debt-to-GDP ratio was over 300 per cent and there were no assets against those debts.

The big point here is that the modern state has enormous financial power. Providing confidence in its own competence is maintained it can borrow on an almost unthinkably large scale. There has been no suggestion of a loss of confidence in a major western government's financial competence or firepower as there was in the 1970s, particularly in the case of the UK. The simple test of that is that governments can still borrow at very low real interest rates, whereas then it was double-digits. So there is no question of governments' financial ability to fix things, even if some seem to be making more of a meal of it than others.

Nevertheless, when the world markets settle down, as they eventually will, the financial landscape will be very different. Credit will be much tighter. Financial regulation will be much tighter. The economy recovery, which I reckon now will be pushed back to 2010, will be slow as debts gradually are worked off. The harsh truth is that the longer it takes to get the banks lending adequately freely again, the longer it will take for normal economic life to resume. The financial fall-out is evident right now; the economic fall-out has hardly begun to settle.

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