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23 October 2008

And still the Chancellor borrows

We are happy to believe in markets in the good times. When times are bad, we run to the state.

By Kwasi Kwarteng

We’re all Keynesians now: bank nationalisation; huge public borrowing; Alistair Darling boasts of spending our way out of the coming recession. Even Boris Johnson has backed 1930s-style public works to boost the economy.

Herein lies madness.

It’s all very well spending money you have. At the heart of Keynes’s ideas is the notion that when times are good, the government builds up a surplus. This can then be spent in bad times to stimulate the economy. It’s not that different from the story about Joseph and his dream of the seven fat cows and the seven lean ones. The seven fat years were followed by seven lean ones. The idea is that you save in the fat years to spend in the lean ones. Some of us learned this at Sunday school.

In the first half of this year we reached the highest level of public borrowing since 1946 (when we at least had the excuse of the aftermath of war). And the Chancellor wants to make the deficit even larger, by borrowing.

We are bust, but the Chancellor wants to spend more money. Capital projects, building roads, bridges and tunnels, are a typically Keynesian prescription. The Japanese tried such projects in the 1990s. They ended up with 15 years of no growth and a national debt 120 per cent of GDP. Today, as a nation, we have no money and lots of debt. Yet the Prime Minister is proposing to spend more. We haven’t seen this kind of silliness in 30 years.

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The only way out is to bring back some fiscal responsibility. We will need restraint. Prudence needs to be brought back urgently. We should not make a bad problem worse by embarking on Millennium Dome-style projects. These will make us more indebted, without giving the economy the stimulus it needs.

What is worse is that we have turned our back on markets. We panicked at the first ebb of trouble. Take the bank bailouts. The banks were not all basket cases. Lehman Brothers was the exception, not the rule.

It was a bank known for aggression, not brains. Its chief executive, Richard Fuld, was called the “gorilla of greed”. Lloyds and Barclays were not comparable. There was a panic; the market was not allowed to find a level for the bank shares. Fund managers were about to invest again in the banks when Paulson and Bernanke stepped in.

Paulson’s plan was the wrong one. Our government correctly identified the problem: the banks needed more capital to protect them from the panic sellers. But where would this capital come from? There were few dissenting voices when Brown said it would be the state. Barclays, to its credit, turned its back on the Brown plan. John Varley, the chairman, felt he could get private investors to support his bank. It will be difficult; but, as I write, only Barclays shares have rallied. At the end of the week of Brown’s interventions, Barclays was up 7 per cent from the start of the week, RBS down nearly 20 per cent, Lloyds down 16 per cent. HBOS shares lost 35 per cent of their value.

There is a sound reason for not putting taxpayers’ money in banks. It isn’t guaranteed that the price of the shares will go up. Let’s say, for the sake of argument, that the value of the shares goes down 50 per cent. The government would then have lost more than £18bn of its investment. Would a responsible government expose the taxpayer to that kind of risk? No.

Despite being slow off the mark, the Americans are now thinking more clearly. Their government is to get 5 per cent on its preference shares, rising eventually to 9 per cent. The UK government is getting 12 per cent on its shares. Any banker will tell you that it is much harder to pay dividends to shareholders if you have a 12 per cent coupon to pay to lenders first. The US deal is more attractive to potential investors.

Barclays, meanwhile, has put its faith in those investors. It wants to get new equity capital from institutions in the Gulf states, China and Japan. There is plenty of money in these countries. Some of these investors have already lost a lot of money buying bank shares this year, yet deals are still being done. There is still an appetite for western bank assets.

Mitsubishi Bank of Japan bought 20 per cent of Morgan Stanley for US$9bn this September, before the fabled Brown plan. China has US$1.5trn of reserves. If you think a deal can’t be done, ask the Barclays shareholders. Then speak to HBOS shareholders. Why would you buy HBOS when you know the bank will have to pay Gordon 12 per cent before you get a penny in dividends?

There has been little real debate about the nature of the bailout. The Keynesian mantra of public works relies on having a surplus to spend. Keynes was not the profligate borrower his admirers have portrayed.

We are happy to believe in markets in the good times. When times are bad, we run to the state. Like spoilt rich kids, we run to Daddy when times are hard, having protested our independence when things were going well.

Milton Friedman died two years ago. He would have been dismayed by all of this. He believed in markets.

Keynes died in 1946, as public borrowing reached new heights. He said the ideas of economists and philosophers were more powerful than people think: “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

In this case it has just been the wrong “defunct economist”, but our current political masters are not even competent Keynesians. They learned the wrong lessons, badly.

Kwasi Kwarteng is a financial analyst and writer and a former chairman of the Bow Group

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