Summary:
Kenneth Rogoff argues that weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigour. Efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem. Number of central banks currently very exposed. Have to ways of dealing with hits to their balance sheet: through inflation, or recapitalisation by taxpayers. Both solutions are extremely traumatic. Fairness issue: why should ordinary taxpayers foot the bill to bail out the financial industry? Poorest will be hardest hit by inflation tax. More regulation is necessary but is not the whole answer. Today's financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future. (Published: 08/09/08)
Notes:
- becoming apparent that, after a period of epic profits and growth, the financial industry now needs to undergo a period of consolidation and pruning
- weak banks must be allowed to fail or merge (with ordinary depositors being paid off by government insurance funds), so that strong banks can emerge with renewed vigour
- efforts to block a healthy and normal dynamic will ultimately only prolong and exacerbate the problem
- not allowing the necessary consolidation is weakening credit markets, not strengthening them
- Fed, ECB and BOE
- particularly exposed
- collectively have extended hundreds of billions of dollars in short-term loans to both traditional banks and complex, unregulated "investment banks"
- not end of the world if central banks are faced with a massive hit to their balance sheets
- but: history suggests that fixing a central bank's balance sheet is never pleasant
- faced with credit losses, a central bank can
- either dig its way out through inflation (inflation tax)
- but: raging inflation causes all kinds of distortions and inefficiencies
- inflation has spiked during the past year, conveniently facilitating a necessary correction in the real price of houses
- or await recapitalisation by taxpayers
- but: taxpayer bailouts are seldom smooth and inevitably compromise central bank independence
- both solutions are extremely traumatic
- fairness issue
- financial sector has produced extraordinary profits
- official US statistics indicate that financial firms accounted for roughly one-third of American corporate profits in 2006
- multi-million dollar bonuses on Wall Street and in the City of London have become routine
- why should ordinary taxpayers foot the bill to bail out the financial industry?
- why not the auto and steel industries, or any of the other industries that have suffered downturns in recent years?
- this argument is all the more forceful if central banks turn to the "inflation tax"
- falls disproportionately on the poor
- have less means to protect themselves from price increases that undermine the value of their savings
- after a period of massive expansion during which the financial services sector nearly doubled in size, some retrenchment is natural and normal
- the sub-prime mortgage loan problem triggered a drop in some financial institutions' key lines of business
- particularly their opaque but extremely profitable derivatives businesses
- some shrinkage of the industry is inevitable
- central banks have to start fostering consolidation, rather than indiscriminately extending credit
- time to take stock of the crisis and recognise that the financial industry is undergoing fundamental shifts
- is not simply the victim of speculative panic against housing loans
- certainly better regulation is part of the answer over the longer run
- but it is no panacea
- today's financial firm equity and bond holders must bear the main cost, or there is little hope they will behave more responsibly in the future
