This has not been a good week for capitalism. I’m not talking here about the stockmarket slump, or the growing evidence of a US recession, or the collapse in UK commercial property funds and subsequent halting of redemptions on several high-profile retail funds. All this is part of the usual rough and tumble of markets.
I’m talking about the fact that markets aren’t working – and haven’t worked for some time – the way they are supposed to. One of the central features of markets – that people must live with the consequences of their risky behaviour – seems to have gone out of the window, with potentially very dangerous consequences for Western economies.
To see what I mean, look at what’s happened over the last week. Investment bankers certainly don’t seem to be required to live with the consequences of their actions. After the top five investment banks announced record bonuses last week, despite being forced to make multi-million-dollar write-downs, Breakingviews calculated that the average employee in these banks last year trousered $250,000 of bonuses, but destroyed an average $375,000 of shareholder value.
Northern Rock shareholders and employees have also been spared yet again the consequences of the bank’s reckless strategy. The Government this week agreed a £50bn smoke and mirrors bail-out – equivalent to a £2,000 loan from every household in Britain – for a medium-sized bank that posed no systemic risk. Meanwhile, the US Fed tried to halt a stockmarket slide and US recession with an emergency 0.75% rate cut, the biggest in 23 years.
This kind of state-orchestrated effort to bail-out investors creates what economists call moral hazard. If risky behaviour goes unpunished, people will do it all over again. The financial system starts to mis-price risk because people start to believe the government will always ride to the rescue. It was Alan Greenspan’s efforts to bail out the US from the consequences of the dotcom crash by slashing interest rates that created this debt bubble in the first place.
What has become clear over the last few weeks is that moral hazard is now hard-wired into the system. Taxpayers are being forced by governments to pick up the tab. Even bankers’ bonuses can ultimately be said to be a gift from taxpayers, as they may not have got a bean if central bankers hadn’t injected so much emergency liquidity into the financial system in the second half of last year.
The problem is that governments cannot continue bailing out investors every time. Eventually, you end up creating a new set of risks that are much harder to control. In the current environment, three obvious ones spring to mind. The first is that the culmination of all this government intervention is to push up inflation. In the US, the Fed funds rate is now below the inflation rate – and forecast to fall further.
Around the world, food prices are soaring and energy prices remain high. If the US rate cuts lead to a fall in the dollar, that too will put pressure on inflation. In the UK, inflation also remains stubbornly high, yet the Bank of England has already come under political pressure to cut interest rates, and the Government’s refusal to confirm a second term for Governor Mervyn King could be seen as a form of covert pressure.
The second risk is that endless government bail-outs weaken Western economies and accelerate the shift in global power from East to West. Cheap credit enabled the West to ignore economic reality for too long. Now Western investment banks are being forced to turn, cap in hand, to Asian and Middle Eastern state-controlled sovereign wealth funds for vital cash injections. The funds may insist they have simply invested because they thought they had got a bargain, but there’s a reason why it was they – and not, say, US investors such as Warren Buffett – who thought the terms were attractive. Ultimately, it would be naïve to believe these funds will not seek some kind of political as well as financial return on their investment.
The third risk stems from the last two: that in the end people will lose confidence in capitalism. Inevitably, some will look at the mammoth bonuses for bankers and the latest government lifeline to Northern Rock and conclude that in capitalism, profits are privatised while risks are nationalised – that it is taxpayers who must always pick up the tab. Meanwhile, they will look at the shift in power to the East that threatens their status and security, fuelling demands for greater protectionism. Needless to say, that will do nothing to increase anyone’s prosperity. But already, one can spot signs of protectionist sentiment all over the world – look at the US election campaign.
Of course, it is naïve to expect anything different from democratic governments operating in a world of fiat money. And of course politicians will do whatever they can to keep people feeling prosperous, and if they won’t use the tools available, then the people can always elect someone else who will. But these bail-outs are not cost free – as we will no doubt find out.
Simon Nixon is executive editor of Breakingviews.com