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What should you do if your banking system doesn't work? Some will doubtless celebrate, arguing that banks are the source of all monetary evil. Others will panic, worrying about the onset of another Great Depression. Policymakers, though, should do neither of these things. They need, instead, to find a way to make the financial system function again.
Banks, after all, are supposed to link the interests of savers and investors. They provide the glue which allows economies to allocate capital through time. Without banks – or some other form of financial intermediary – modern-day economies would implode. You've only got to go back to the Great Depression to see what happens when a banking system melts down.
Why is the system in such bad shape? Many reasons spring to mind, ranging from collapsing housing markets to pro-cyclical fair-value accounting and dodgy mortgage-backed securities, but it's the loss of trust which is the biggest single problem. Banks have a habit of lending to each other in the so-called interbank market. They'll do so, though, only if they're confident that they'll get their money back. Recently, trust has been in short supply. Banks circle each other suspiciously, unsure of the hidden dangers associated with lending to their counterparts. We're seeing a modern-day wholesale version of the bank run. It's not so much that customers are withdrawing their deposits (although, to a degree, they are). Instead, banks are simply refusing to lend to each other.
Arguably, matters have been made worse by policymakers who have adopted a piecemeal approach to bailouts. Lehman Brothers was allowed to fold but AIG was saved, leaving some stockholders penniless but others a bit better off. Washington Mutual's rescue left its creditors severely out of pocket, while, at the time of writing, Wachovia was to be sold either to Wells Fargo or, with the help of taxpayers' money, to Citibank. In the absence of systematic government policies, banks are finding themselves playing a game of financial Russian roulette.
If, though, this is the ultimate "do", what about the "don'ts"?
First, central banks should not defend their independence at all costs. This, after all, is what the Federal Reserve did during the Hoover administration at the beginning of the 1930s. The approach was a hopeless failure. During banking crises, central banks lose their power. To restore it, they need, and should ask for, fiscal help.
Second, each central bank should, ideally, speak with one voice. Better, in my view, to show strong leadership than to advertise publicly a collection of disparate views which can only sow the seeds of doubt throughout the financial system. After years of success in highlighting the nuances of the economic debate, we're now seeing the downside to the Bank of England's committee system.
Third, under no circumstances should countries resort to capital market protectionism. The Irish government's offer to underwrite deposits in Irish banks (and, hence, to protect the Irish banks' interests) is an unfortunate precedent (it would be far better if all countries were to offer deposit guarantees simultaneously, but that hasn't happened). It's reminiscent of the Smoot-Hawley tariff in 1930, designed to protect the interests of American exporters but, ultimately, a contributor to the subsequent collapse in world trade. Others were forced to launch their own "beggar-thy-neighbour" policies, contributing to a global economic collapse and, tragically, fanning the flames of fascism. We don't want to go down that route again.