Free markets and state intervention

For students of economic history, none of the recent financial markets turmoil should be too surprising. Booms and busts are a persistent, if unpredictable, feature of free (and not so free) markets. Last week's threatened bust was on a scale way bigger than anything in living memory. It looked like the financial system would completely implode. Japan may have had problems with its bank failures in the 1990s. The Asian crisis of 1997-98 was a truly awful experience for those involved. One has to go back to the 1930s, though, to find a situation resembling the experiences of the past few days.

Most people think the Great Depression was a consequence of the Wall Street Crash in October 1929. While partially true, it is not anything like the whole truth. The crash triggered a desire to hold cash as opposed to riskier assets. This left banks, which typically raise liquid funds to invest in illiquid assets, in a vulnerable position. As panic spread, so more banks went bust. There were four separate banking crises in the early 1930s, leaving the US economy starved of credit. Demand collapsed and unemployment soared; 9,000 banks went bust. At the peak, a quarter of the American workforce was out of a job.

Academic studies suggest that, had the banks not failed, the human cost of the Great Depression would have been much diminished. While there would still have been a deep recession, it would have been nothing like as big as the 30 per cent fall in output which actually occurred.

Ben Bernanke is undoubtedly one of the world's foremost experts on the Great Depression. It is, therefore, fortunate that he's in charge of US monetary policy today. It is also very good news that the Federal Reserve and US Treasury are working together to deal with the problem. In the early 1930s, the Federal Reserve jealously guarded its independence, refusing on moral hazard grounds to re-liquefy the financial system, a view which doubtless contributed to the subsequent economic collapse. It wasn't until the election of Franklin D. Roosevelt at the end of 1932 that fiscal and monetary heads were banged together and it was only then that the US economy began to recover.

The scars left by the Great Depression span the generations. Bernanke and Hank Paulson, his brother-in-arms at the US Treasury, have no intention of going down the same route again. Having spent the past year or so worrying about the balance between moral hazard and a banking bail-out, they have accepted that, , moral hazard will have to be put to one side.

In Paulson's words: "We must now take further, decisive action to ... address the root cause of our financial system's stresses. The underlying weakness in our financial system today is the illiquid mortgage assets that have lost value as the housing correction has proceeded. These illiquid assets are choking off the flow of credit that is so vitally important to our economy."

Paulson is proposing to use American taxpayers' money to buy those illiquid assets, hoping that banks and other institutions will be able to trust one another again, easing the credit squeeze which has done so much to imperil economies the world over.

One hopes the Paulson plan will work. It will not be easy. Which mortgage assets will be purchased? At what price? Will the US taxpayer only be asked to buy the assets of American banks? What about foreign banks operating in the US? And US banks operating abroad? And will Congress agree to the plan?

The Paulson plan is, of course, based on the Resolution Trust Corporation (RTC) launched in 1989 to buy up the assets of failed Savings and Loans institutions. That, though, was a uniquely American problem. The Paulson plan will have to be a lot more ambitious. It will need global reach. And, to restore trust in the banking system, it will need to buy up assets from the balance sheets of banks which, until now, have just about remained both liquid and solvent.

While the most recent euphoria is understandable, the longer-term consequences of the crisis will surely require a more sombre approach. First, although the original RTC helped clear up some of the mess left behind after the late-1980s, the US economy still went into recession in 1990 and a genuine economic recovery had to wait until 1994.

Second, there is the cost to the taxpayer. It's difficult to know at this stage to determine how many assets will have to be purchased. Perhaps those assets will subsequently rise in value, leaving the taxpayer with a healthy profit.

Third, the 1930s left the world economy with a legacy of protectionism, capital controls and market inefficiencies which most economists think reduced people's living standards. It could happen again. Fourth, having given the US economy the benefit of the doubt for years, perhaps foreign creditors will turn their backs on US assets, undermining the long-term growth rate of the world's biggest economy.

This report was compiled by the Marketing Department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.