The role of the State in times of crisis

9 October 2008

As the scale of a crisis grows, the authorities tend to become more generous, according to BI researcher Erlend Kvaal. Short-term considerations dominate.

In a socio-economic perspective the function of the financial system is to receive savings from those who have a surplus and invest the assets where it yields the highest return.

The financial system is in a crisis when it clearly does not master this task. The fact that one financial institution is in trouble (such as UNI Storebrand in 1992) does not constitute a system crisis because the customers can seek alternatives.

A system crisis arises when all the suppliers are struck by the disease (such as the Norwegian banks in 1990-1991).

The nerve centre of global capitalism

Even though there are some common denominators between the Norwegian bank crisis and the current financial crisis, the differences are more prominent. The most important difference is that today’s crisis is of a completely different dimension than anything we have seen before. The Norwegian bank crisis was one of several local bank crises that took place in the 1980s and 1990s – in the USA, Scandinavia and Japan. The crises dealt some hard blows, but none of them had a noticeable global impact. In comparison, today’s crisis has struck smack in the middle of the global capitalism’s nerve centre, and everyone notices the impact.

Can financial crises be prevented?

Can financial crises be prevented? As financial crises have surfaced in various forms as long as mankind has lived in a capitalistic society, it is difficult to give an affirmative  answer to this question. A more reasonable question would be whether the impact of the crises can be subdued through preventive measures. In my opinion it is important to discover markets where a short-term equilibrium price cannot be maintained in the long run, for example a housing market priced so that normal incomes cannot cover the cost of capital for ownership. In such markets the home buyers and lenders will make dispositions on the basis of a continued price increase, and this will prove to be a good strategy for long periods of time, even though it functions as a pyramid scheme in the long run.

The scapegoats of the financial crisis

Determining a long-term sustainable price is, however, not a clear-cut matter. In the light of this, I find the characterisation of greedy bankers as scapegoats of a financial crisis to be out of line. If anyone has the competence and instruments to counteract the prices of capital assets from developing into a pyramid scheme, it has to be the authorities, particularly in their exercising of fiscal and monetary policies. The American Republican John McCain singled out two scapegoats during his campaign: the Securities and Exchange Commission and the accounting rules – the first blamed for having done a poor job and the accounting rules for requiring market value of assets to be posted in the balance sheet. I will not comment on that viewpoint, but: a financial supervisory authority does an important job, but a job that is more concerned with weeding out bad elements in normal times rather than counteracting meltdowns when they arise. And whether the balance has been posted at the historical cost or market value may be significant for pricing in the market under normal circumstances, but hardly in times of crisis.

When confidence fails

Lehman Brothers posted their entire balance (assets and commitments) at market value and reported a loss the size of one fourth of opening equity in the course of the first three quarters of the year (until 31 August). In other words, most of the equity capital was intact at the time liquidity vanished. Banks are priced on the basis of expectations of future earnings conditional on an asset that has not been posted in the accounts; trust. When confidence fails, the accounting values become irrelevant, regardless of the accounting model.

The crisis becomes a fact

When the crisis becomes a fact the question arises as to what should be done. The basic belief of the authorities is always that the market itself has to resolve the problems that arise when a financial institution seems likely to topple over. But the ripple effects of a bankruptcy in the financial industry are many and complex.

So as a crisis grows, the authorities become more open-handed. The costs of letting financial institutions go bankrupt are outweighed by the costs of rescuing them. This is a trade-off with a significant list. The costs of a bankruptcy are unknown and are fairly imminent, and many affected parties have their own interests at heart in highlighting them. The short-term costs of a rescue operation can be calculated.

State intervention – not necessarily the best solution

The long-term costs of a rescue operation - a less efficient financial market because the players can afford more relaxed assessments when they are aware of a State safety net – are nearly impossible to quantify. This more or less dictates how such a trade-off will end. It does not necessarily follow that State intervention is the best solution.

Yet another element has a tendency to intervene with the decision-makers; the desire to preserve national control. If I (on a highly uncertain basis) were to surmise a contra-factual course of events without State intervention in the Norwegian bank crisis, I would foresee a short-term real economic turbulence with a fast foreign acquisition and continuation of profitable financial segments.

One may then ask what would be the best and the worst solution today; a Norwegian-owned financial industry where major institutions enjoy an implicit State guarantee or a predominantly foreign-owned industry without such competition restrictions.

I would guess that in the USA as well there is broad political consensus on not letting vital financial institutions being sold cheap to just anybody, even though no one says so out loud.

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