Peston's Picks

How much will taxpayers finance economy?

• Robert Peston
• 5 Dec 08, 11:13 AM

You know the world has changed when Jim O'Neill, the chief global economist of Goldman Sachs - the investment bank that defined the culture of bonus-driven, globalised financial capitalism - grumps on the Today Programme that our government probably needs to create a state bank that will provide the vital credit that our commercial banks cannot provide.

He's been banging on about this for months - because, as you know, it's been obvious for rather longer that the source of our economic woes is the savage contraction of lending by banks all over the world.

And the credit squeeze is particularly acute here.

So Goldman Sachs votes for socialist, state-directed lending. The symbolic power of this thought is mind-numbing, for those of us who immersed ourselves in the liberalised, winner-takes-all financial markets of the past 25 years.

Next week I'm going to write about the long-term implications of the failure of financial markets and the rise of the taxpayer as the new source of credit for the banking system and the real economy.

What kind of capitalism will emerge from the rubble?

But right now I want to look at the contradictions in government policy towards the banks - and the difficult choice it faces about how to revive lending.

The important point, which I've made many times before, is that the £600bn (and rising) of loans, guarantees and capital provided by taxpayers to rescue the banks does not encourage them to lend more, and may actually contribute to the contraction of lending.

For example, the terms of the £250bn credit guarantee scheme - which allows banks to borrow for up to three years from markets with taxpayers standing behind that debt as guarantor - are extremely expensive. So banks have no incentive to take advantage of the scheme to raise funds for lending to all of us.

The £200bn they're raising from the Bank of England by swapping mortgage-backed securities for Treasury bills has to be paid back in three years - which does not feel to banks like an eternity at a time when there's a global shortage of capital and credit.

And the preference shares that three of our biggest banks have been forced to sell to taxpayers are very expensive for these banks. So they want to redeem them as soon as possible - thus giving them another powerful incentive to shrink their balance sheets, reduce lending and prove to regulators that they no longer need the preference capital.

Then there's the impact of the Basel II global rules on how much capital banks need to hold relative to certain kinds of loans. Those rules make it hideously expensive for banks to provide mortgages to first-time buyers, by stipulating that banks have to hold massively more capital for a mortgage when the deposit on a house is 15% of value compared with when its 25%.

Also, as house prices fall, Basel II obliges the banks to raise yet more capital to cover the declining value of collateral held against their £1,200bn of mortgages.

Finally, as the FSA confirmed yesterday, the banks are being forced to hold hundreds of billions of pounds of additional government bonds.

Why?

Well, government bonds are liquid, so when banks have relatively more of them the risk is reduced that they'll fall over (a la Northern Rock) after wholesale markets shut down in the way they did in August 2007.

Which is all very well, except that the more gilts and other high quality government bonds that our banks are obliged to buy, the less capacity they have to lend to households and businesses.

So what are the policy options for government?

Well, the Treasury could, for example, revise the terms of the Credit Guarantee Scheme and perhaps expand it, so that banks start to use it on a substantial scale to raise money for lending to all of us.

And it could also provide taxpayer guarantees for other, more long-term borrowing from money-managers and other financial institutions - something along the lines of the sovereign-guaranteed, mortgage-backed securities proposed by Sir James Crosby in his recent report for the Treasury.

I get the feeling, however, that Crosby's narrow suggestion for how to revive the mortgage market has rather slipped down the Treasury's list of priorities.

What is higher up the government's agenda is an increase in explicit taxpayer support for any kind of lending to the real economy, or lending to small businesses, big businesses and households.

It could take a number of forms.

There could be taxpayer guarantees for real-economy loans packaged up into bonds, similar to what Crosby suggested for mortgage-backed bonds.

However, there is evidence from markets that even if these bonds were converted in this way into the equivalent of UK government bonds, so that they were an explicit claim on taxpayers and the state, they still wouldn't be bought by money managers.

You can see this in the failure of Northern Rock, a wholly nationalised bank, to increase its funding on attractive terms from wholesale markets.

Money managers apparently don't want to buy into the UK housing market, even when the risk is covered by HMG. And they may have the same qualms about buying any kind of asset-backed security, even when it's gilt-edge or underwritten by taxpayers.

So there are two alternatives. One would be O'Neill's state-owned, state-funded bank.

The other would be a longer-term, broader more ambitious version of what's already happening here and in the US. Which is that banks could package up loans to businesses and households and then exchange them for cash from the Bank of England.

In effect, we as taxpayers would be funding the bulk of the real economy.

It sounds extreme. There are big and serious issues about whether such an initiative would be perceived by international investors as seriously weakening the strength of the public-sector balance sheet, such that there would be a damaging run on the pound.

And it would probably only persuade our banks to lend more if there was a commitment from the Treasury and the Bank of England that this funding from taxpayers would be available for many years (certainly much more than three years) - which would represent a radical re-making of how capitalism operates.

However, such a substantial increase in the provision of credit by taxpayers has to be a serious option, because the sunny economic uplands won't be visible again until a solution is found to the vicious, inexorable contraction of lending.

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