When the dust settles on the financial market mayhem of the last few months, one consequence will probably stand out from all others. The unfettered free-market capitalism and minimal state model will be gone.
Even before the latest financial crisis, the political mood was shifting. Concerns about the environment, income distribution and migrant labour were all adding to doubts about the free-market model. It is, therefore, highly probable that the state will return as a major economic force.
The financial crisis has already, perhaps inadvertently, led to much bigger state involvement in economic affairs. As Citigroup, Merrill Lynch and others sold off chunks of their businesses to the Chinese, the Singaporeans and the Gulf nations, sovereign wealth funds acquired the ability and the willingness to own big shares of supposedly free-market companies.
This, in turn, raises an obvious question. What if the major shareholders in a company do not fully subscribe to free-market tenets? Years ago the UK government argued in favour of privatisation because it exposed company managements to capital market discipline. This argument only works, though, if those within the capital markets are interested in maximising their financial returns. It is not clear that all sovereign wealth funds will act in this manner.
If they do not, how should Western governments react? The obvious answer is to regulate to ensure that the interests of other stakeholders - consumers, workers and other shareholders - are met. Hence, an escalated level of state involvement ...
In many ways, the involvement of the sovereign wealth funds was a stroke of good fortune. Banks desperately short of capital might otherwise have had to resort to fire sales of assets and, even worse, rights issues. That, in turn, would have weighed even more heavily on the world's bourses.
The biggest consequence is the return of state involvement, whether voluntary or otherwise, in each nation's domestic macroeconomic affairs. Over the last few years, everyone got used to the growth of international capital markets, with ever-increasing, cross-border capital flows. For a while this meant that sub-prime households in the US, for example, could borrow indirectly from, say, local councils in Norway. The device linking these seemingly-disparate creditors and debtors was global capital markets.
When, however, trust falls out of the bottom of the market - as happened in recent months - who ultimately is responsible for sorting out the problem? Is it the banks, which originated and then sold off so much paper? Is it the households who should not have borrowed so much in the first place? Or is it the Norwegian local councils and their ilk who perhaps should have been more aware of the risks they were taking when buying increasingly-exotic financial products?
The truth, of course, is that while each of these has an interest in finding a solution, none of them, on its own, is probably capable of doing so. The weakness and enhanced volatility of capital markets in recent months has been a consequence of a monumental collapse in levels of trust. Whether it is corporate bonds, asset-backed securities or, more recently, equities, investors no longer see any of these assets as a safe store of value.
Only one group of assets is seen as trustworthy at the moment. Whether in the US, the UK or the eurozone, government bonds are in hot demand. Yields are remarkably low but no one is looking for decent returns. They are much more interested in keeping existing capital safe.
It is for this reason that governments will have a bigger role to play. If government yields are so low, governments can borrow from the capital markets cheaply and easily. Whereas both households and companies are succumbing to the credit crunch, governments have easy access to funds. As a result, they may find themselves playing a much bigger role supporting economic growth.
The Americans already appear to have recognised this turn of events. With remarkable speed, US Congress and the administration have come up with a fiscal package worth over $100 billion, enough to add about 1 per cent to economic growth, even though the American fiscal position is nowhere near as healthy as it was ahead the 2001 downswing. This stimulus plan may not be enough to avoid recession but it should certainly help to limit the scale of any initial economic contraction. Elsewhere, though, there is no such debate.
Arguably, of course, this reflects America's unique economic problems. The housing market is imploding, unemployment is rising and many of the usual recessionary indicators are flashing red. The same cannot yet be said for the UK or for countries within the eurozone.
It may only be a matter of time. The sub-prime crisis started in America but the systemic risks to the financial system are transatlantic in nature. Failing capital markets carry consequences for economic growth on both sides of the Atlantic, and to pretend otherwise would be foolish. To deal with the crisis a fundamental rethink of the relationship between fiscal policy and the broader economy may be required. Broadly, two arguments favour low and stable budget deficits. First, low deficits are consistent with the maintenance of price stability. Second, low deficits provide freedom for the private sector to allocate capital efficiently.
Yet these arguments are not universally true. Banking crises tend to be associated with persistent periods of weak demand and, hence, low inflation. And when capital markets fail, their failure is typically the result of earlier periods of inefficient capital allocation. In other words, there are times when governments really do need to borrow if a calamitous economic downswing is to be avoided.
Is another one of those occasions approaching? Well, American policymakers have already half-admitted this. In other countries, the debate has not even started. It must, though, before it is too late.
• This report was compiled by Peter Calleya, manager for corporate strategy and research at HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Even before the latest financial crisis, the political mood was shifting. Concerns about the environment, income distribution and migrant labour were all adding to doubts about the free-market model. It is, therefore, highly probable that the state will return as a major economic force.
The financial crisis has already, perhaps inadvertently, led to much bigger state involvement in economic affairs. As Citigroup, Merrill Lynch and others sold off chunks of their businesses to the Chinese, the Singaporeans and the Gulf nations, sovereign wealth funds acquired the ability and the willingness to own big shares of supposedly free-market companies.
This, in turn, raises an obvious question. What if the major shareholders in a company do not fully subscribe to free-market tenets? Years ago the UK government argued in favour of privatisation because it exposed company managements to capital market discipline. This argument only works, though, if those within the capital markets are interested in maximising their financial returns. It is not clear that all sovereign wealth funds will act in this manner.
If they do not, how should Western governments react? The obvious answer is to regulate to ensure that the interests of other stakeholders - consumers, workers and other shareholders - are met. Hence, an escalated level of state involvement ...
In many ways, the involvement of the sovereign wealth funds was a stroke of good fortune. Banks desperately short of capital might otherwise have had to resort to fire sales of assets and, even worse, rights issues. That, in turn, would have weighed even more heavily on the world's bourses.
The biggest consequence is the return of state involvement, whether voluntary or otherwise, in each nation's domestic macroeconomic affairs. Over the last few years, everyone got used to the growth of international capital markets, with ever-increasing, cross-border capital flows. For a while this meant that sub-prime households in the US, for example, could borrow indirectly from, say, local councils in Norway. The device linking these seemingly-disparate creditors and debtors was global capital markets.
When, however, trust falls out of the bottom of the market - as happened in recent months - who ultimately is responsible for sorting out the problem? Is it the banks, which originated and then sold off so much paper? Is it the households who should not have borrowed so much in the first place? Or is it the Norwegian local councils and their ilk who perhaps should have been more aware of the risks they were taking when buying increasingly-exotic financial products?
The truth, of course, is that while each of these has an interest in finding a solution, none of them, on its own, is probably capable of doing so. The weakness and enhanced volatility of capital markets in recent months has been a consequence of a monumental collapse in levels of trust. Whether it is corporate bonds, asset-backed securities or, more recently, equities, investors no longer see any of these assets as a safe store of value.
Only one group of assets is seen as trustworthy at the moment. Whether in the US, the UK or the eurozone, government bonds are in hot demand. Yields are remarkably low but no one is looking for decent returns. They are much more interested in keeping existing capital safe.
It is for this reason that governments will have a bigger role to play. If government yields are so low, governments can borrow from the capital markets cheaply and easily. Whereas both households and companies are succumbing to the credit crunch, governments have easy access to funds. As a result, they may find themselves playing a much bigger role supporting economic growth.
The Americans already appear to have recognised this turn of events. With remarkable speed, US Congress and the administration have come up with a fiscal package worth over $100 billion, enough to add about 1 per cent to economic growth, even though the American fiscal position is nowhere near as healthy as it was ahead the 2001 downswing. This stimulus plan may not be enough to avoid recession but it should certainly help to limit the scale of any initial economic contraction. Elsewhere, though, there is no such debate.
Arguably, of course, this reflects America's unique economic problems. The housing market is imploding, unemployment is rising and many of the usual recessionary indicators are flashing red. The same cannot yet be said for the UK or for countries within the eurozone.
It may only be a matter of time. The sub-prime crisis started in America but the systemic risks to the financial system are transatlantic in nature. Failing capital markets carry consequences for economic growth on both sides of the Atlantic, and to pretend otherwise would be foolish. To deal with the crisis a fundamental rethink of the relationship between fiscal policy and the broader economy may be required. Broadly, two arguments favour low and stable budget deficits. First, low deficits are consistent with the maintenance of price stability. Second, low deficits provide freedom for the private sector to allocate capital efficiently.
Yet these arguments are not universally true. Banking crises tend to be associated with persistent periods of weak demand and, hence, low inflation. And when capital markets fail, their failure is typically the result of earlier periods of inefficient capital allocation. In other words, there are times when governments really do need to borrow if a calamitous economic downswing is to be avoided.
Is another one of those occasions approaching? Well, American policymakers have already half-admitted this. In other countries, the debate has not even started. It must, though, before it is too late.
• This report was compiled by Peter Calleya, manager for corporate strategy and research at HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.