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Bailouts, rescue plans, stimulus packages ... Like most of us, Aida Edemariam didn't understand where the money was really going. So she asked the experts to explain. Very slowly
It sometimes seems as though every day another bank or building society needs to be shored up as fast as possible - or else life as we know it will come tumbling down. And as the emergency scaffolding becomes ever more byzantine, so the whole thing becomes ever more baffling to those of us who didn't do economics at school, and had to have our mortgages explained to us very slowly, in words of one syllable.
What we do understand - or, more realistically perhaps, often don't quite understand but are gobsmacked by - is the size of the numbers involved. £500bn rescue packages. £37bn bailouts. Responsibility for £260bn-worth of risky assets. £75bn in quantitative easing. £20bn stimulus packages. (Not to mention President Obama's nice round trillion-dollar rescue plan.)
That, regardless of your levels of comprehension, sounds like a lot of money. Where is it coming from? Surely our taxes can't be paying for all of it? Where is it going? Will we ever see any of it again? What do all those words mean? I called economists, I called thinktanks. I contacted the Bank of England. Some were very patient, others condescending. The Financial Services Authority simply referred me to the Treasury. Nearly everyone, in fact, eventually pointed me to the Treasury. The Treasury sounded tired.
In the end, I began at the very beginning. The nature of money seemed a very good place to start. Money is all about trust. Even cash is only a promise. Look at a £10 note: "I promise to pay the bearer on demand the sum of ten pounds." As the economic historian Niall Ferguson puts it in his most recent book, The Ascent of Money, "Money is a matter of belief, even faith: belief in the person paying us; belief in the person issuing the money he uses or the institution that honours his cheques or transfers. Money is not metal. It is trust inscribed. And it does not seem to matter much where it is inscribed: on silver, on clay, on paper, on a liquid crystal display. Anything can serve as money, from the cowrie shells of the Maldives to the huge stone discs used one the Pacific islands of Yap. And now, it seems, in this electronic age, nothing can serve as money too."
Only about £44bn exists, in the UK, as physical, touchable cash: notes and coins. Everything else - £1.98 trillion or so - is bank deposits not backed by cash (or, these days, gold). Then there's wealth. Wealth - as opposed to income - describes the value of our assets. How much our homes are worth, for example. How much our shares or bonds are worth. And that depends on all sorts of things - the state of the economy, the financial markets, decisions made by investors, all linked by that old intangible, confidence. It can change from month to month, minute to minute.
And a lot of wealth isn't actually real until you sell your house, or your shares. Bonuses, for example, are paid on the basis of the wealth of a company; ie on the basis of an assumption, or a projection, of what a company is worth at a particular point in time. The minute a bonus is cashed in, however, that money becomes real, and leaves the system. The bonuses that have caused all the furore - £16bn or so, over 2007 and 2008 - were based on pre-crash projections. Hence the great imbalance between payouts and the suddenly shrunken wealth of the companies. (And hence the foolishness of the people who insist on taking them - they are damaging the trust required to ensure the health of their institutions in the long term.) One answer, then, to the question "Where Has All the Money Gone?" is that a lot of it was never there in the first place. "It was imaginary money," says Douglas McWilliams, chief executive of the Centre for Economics and Business Research. Trust collapsed, and the wealth went with it.
To understand exactly how this happened, it helps to picture a classic bank balance sheet, and Thomas Kirchmaier, a visiting fellow at the London School of Economics who is making a specific study of the credit crunch, walks me through one. Imagine two columns. On the left are the positives; the assets. Loans, for example. Also our mortgages, because we pay all these things back, with interest, every month. (If you've ever been brave enough to look at the total amount you'll pay over a term of 25 years, you'll know that this is a pretty lucrative deal for a bank.) On the right are the liabilities. Deposits, for example, because we can take them out at any time. Also shares, also known as equity. A bank's shareholders will each have paid a certain amount for a certain number of shares, and in good times, these shares are worth more than was paid for them, hence increasing the amount of capital at the disposal of the bank. But their value dips and rises according to the confidence of the stock market. If confidence is low they can be worth very little. They are thus high risk - but they are what buffers a bank if a borrower on the left side of the balance sheet defaults. The riskier the loans on the left-hand side, the more equity you need.
In the prelapsarian era, before most of us had ever heard of sub-prime mortgages, before Northern Rock, before Merrill Lynch, the banks were awash with equity, and happy to lend it to each other. As Alistair Darling mentioned in his evidence to the Treasury Select Committee two weeks ago, China was partly at the root of it. The success of its economy meant that it could provide the US with seemingly limitless credit, which meant that US interest rates could be kept artificially low.
Cheap Chinese goods also kept the cost of living down. The combination encouraged many to borrow beyond their means. When, for various reasons, including the quickly climbing cost of oil (partly caused by the Iraq war), Alan Greenspan of the US Federal Reserve increased interest rates, millions couldn't afford to pay their mortgages, and defaulted. The overconfident banks hadn't matched their reserves to their assets. There simply wasn't enough there to cover their losses. The system seized up.
The obvious question, to my mind at least, is, if it was all imaginary in the first place, why can't we just write it all off and start again? Why can't we consign it all to an imaginary dustbin, instead of throwing yet more money into a hole we don't know the depth of? Because, as the Treasury spokesman would say with a slight sigh, to do so would instantly decimate the complex web of salaries, house-buying, businesses (most of which can't function without the flexibility provided by bank credit) and general day-to-day consumption otherwise known as a western economy.
"We are a capital-intensive society," says Kirchmaier. "This makes us more productive, and wealthier. Ending a capital-intensive society would mean sending us back to the stone age. We have seen instances in history where states tried to renegotiate their debt and start all over again. Germany after the first world war was such a case, or Zimbabwe now. None, I would say, counts as a success story." (We are also a society founded, for better or worse, on credit, a society in which one can be refused a credit card if one has no evidence of previous borrowing: if you have always lived within your means you have no credit rating. I think this is bonkers, but maybe that's just me.)
So the big banks have to be propped up regardless of the mess they're in, so that they can, eventually, lend us money, and we - individuals, companies - can start spending again. But the banks are freaked out. They'd much rather sit tight and watch their capital grow. They are also not keen to lend to anyone who would be at the slightest risk of defaulting. (It doesn't help that there has been a precipitous drop, about 20%, in foreign bank loans. When foreign banks got into trouble - remember Iceland? - they retrenched.)
It's not all their fault. We're freaked out too, and don't want - and in many cases can't afford - to borrow anything. The natural instinct, just as it is with the banks, is to save; to know you have money where you can see it (even though it's not growing in value because interest rates are so low). And from the government the banks are getting contradictory advice. On the one hand, it is - understandably - demanding more prudent banking. On the other, it wants the banks to lend, and lend now. In late February, fed up with waiting for the banks to do the decent thing, they made the order legally binding: according to Vicky Redwood, UK economist at Capital Economics, RBS has to lend an extra £25bn this year, £9bn of which must be in mortgages, and Lloyds must lend £14bn, £3bn of which must be in mortgages - all of it guaranteed, in various expensive ways, by the government.
And that, to put it simply, is where a lot of the money has gone: to patching up the holes in banks' balance sheets, so they don't go under. And what has it cost? Understanding that means trying to understand the various mechanisms by which the government is intervening. Let me count the ways.
First, there is direct nationalisation, in which the government simply takes charge of the bank - deposits, bad debt, equity, staff, the lot - using trust in the fact that it is a government as the ultimate guarantee that no one's money will be lost, come hell or high water. This applies to Northern Rock, nationalised on 18 February last year, and Bradford & Bingley, nationalised on 29 September. It also applies to 70% of RBS, and 70% of Lloyds-HBOS. It cost £12.9bn to bail out Northern Rock; the government now owns £113bn of its liabilities, as well as its assets. Bradford & Bingley had £22bn in deposits and 200 branches, which were sold on to Banco Santander for £400m - which would seem like a gain for the government, except that it then had to pay Santander £4bn to guarantee the deposits.
Nationalisation can work out quite well for a government eventually - when Sweden bailed out and thus stabilised its banks in the 1990s the public actually made a profit - but the downside is that, if things go wrong, the government is exposed to all the risk. It also doesn't want to be stuck running banks. Doctrinally, different countries have different attitudes to nationalisation. In America it's a dirty word; France would probably do it like a shot. Here we apparently prefer banks to be run, in the Treasury's catchphrases, on a "commercial basis" and at "arm's length": ie, the Treasury believes, all evidence so far to the contrary, that the private enterprise system is best placed to make judgments about how banks should work.
The second is to buy equity in a bank - ie buying shares like any other shareholder, adding value to the right-hand side of the balance sheet, and thus guaranteeing all the assets on the left-hand side. (Quite often the government has insisted that these shares be preference shares: ie any profit, and thus dividends, must be paid to the government first.) Of course, as with any other shareholder, the government's money is now hostage to the stock market - but the gamble is that increased confidence in the banks means the value of stocks will go up - which has, as Nick Parsons of NAB Capital points out, actually been happening in the last couple of weeks, for the first time in three years. The idea is to sell these shares when the bank finally turns a profit - which could take decades.
Finally, there is insurance. Technically, in this scenario, the banks are paying the government, rather than the other way round. Imagine a common-or-garden insurance policy: your contents insurance, say, or travel insurance. You pay a premium of, say, £14 to the insurance company; they promise that if the worst happens and you fall ill in a foreign country, they will pay the medical bill (which you otherwise might not be able to afford). So the banks - Lloyds, most recently - pay a fee to the government, and the government promises to pay for any large losses the bank then incurs: up to £325bn in the case of RBS, and up to £260bn in the case of Lloyds. This means that banks do not have to hold (or raise) more equity. The ideal is that now that the government has stepped in to calm nerves, the economy recovers, and there will be no further problems, and that this particular solution will turn out to be a zero-sum game: ie that there is no net cost to the government.
The problem is that in any normal insurance setup the insurance company has a pretty good idea of the likelihood of it having to pay up - the probability of floods, for example, or volcano eruptions - and that is usually fairly small. With the banks, no one has any idea how far the rot spreads, or how bad things could get, so the government could easily be on the hook for hundreds of billions. Also, as Kirchmaier points out, the premiums paid by the banks are unlikely to be high enough. "I believe that we as a taxpayer have the right to receive the upside."
Anyway. As it stands at the moment, the government has paid out, in fresh monies, rather less than it might seem from a layperson's perusal of the headlines. If we just counted "bailouts" - the rather lazy, catch-all term for all the above methods, regardless of whether they actually involve a transfer from the government to a bank - since September 2007, when Northern Rock was given £4.4bn, we could easily come to the shocking figure of £1.2tn. In fact, the figure, according to Jonathan Loynes, chief European economist at Capital Economics, "actual cash layouts, real, up-front money, have been relatively small - just £30bn, which will rise to about £50bn when the government injects promised capital into RBS and Lloyds". The Treasury has also spent about £5bn compensating depositors in Bradford & Bingley and the Icelandic banks; added to a loan to the Financial Services Compensation scheme, this means that they've had to raise about £90bn this year.
But this is still a huge amount of money. Where does it come from? It's easy to assume (because it's how we might run our own finances) that it just gets diverted from one thing to another. Dresses to food, restaurant meals to baked beans, hospitals to banks - but a lot of government money just isn't discretionary in that way (yes, I know this is arguable). More importantly, the chancellor is determined that spending on the economy dips as little as possible, so it stays as healthy as possible. So, rather like a household throwing up its hands and getting a personal loan, this money is borrowed.
Specifically, the government is borrowing money by auctioning bonds. A bond is where the government borrows money using its own coffers (which consists largely of our taxes, now and in the future) as a guarantee that it will be paid back, with interest. These bonds are being bought by various institutions, such as UK pension funds and insurance companies; UK banks (which is fantastically counter-intutitive, but in fact if it borrows from a UK bank it is propping up the left-hand side of its bank balance, provided the term of the loan is sufficiently short); and foreign investors, such as Saudi Arabia or China. (This is where worries about money leaking abroad come in. Overseas investors own just over a third of all bonds in issue.) There is also quantitative easing - an incestuous mechanism by which the government issues bonds to the Bank of England - in effect, printing money.
Buying bonds has traditionally been seen as a pretty safe way of investing: surely the government must be the most trustworthy of creditors, and so you'll get your money back, with interest (hence their other name, gilts, as in "gilt-edged")? But last Wednesday the government failed to sell all the bonds it had issued. Buyers were casting doubt on the government's ability to repay its own debts. The bond market recovered the next day, but it was a shot across the bows.
And that's only when it's trying to pay for the direct cost of propping up the banks so far. The indirect costs are much greater, and we don't hear quite as much about them.
The fact is that government spending is based on projected tax income - much of it from the previously booming financial sector: the Treasury, notes McWilliams, has made more money from the financial sector in the last 20 years than it's had to pay in bailouts over the last two. It may have been imaginary money, but it was taxed as if it was real money - and so successive chancellors have spent it, and built their budgets around it.
And that income has shrunk dramatically. A study by the Centre for Economics and Business Research has found that tax revenues from the financial sector in the financial year 2009/2010 will drop by £28bn when compared with the previous year. That is a loss equivalent to 80% of the defence budget, or 30% of the health budget.
And that is not to count all the other effects of the resulting recession. Fewer of us are in work (according to Parsons, a job was lost every 17 seconds in February) and we are being paid less - hence fewer taxes will flow to the government. Every company that goes bust (we only need to look at our high streets to realise how often that is happening) represents a drop in corporate taxes. At the same time, the benefits bill, paying for all those people out of work, will rise, sharply. "For every 1% you lose in GDP," says McWilliams, "you lose about £10bn." Loyne expects that by 2010-11, the GDP will be about 10% lower than the chancellor anticipated in his 2008 pre-budget report - which would push annual public borrowing up by over £100bn. The chancellor is effectively spending many billions we don't have. Figures from Capital Economics suggest that public debt may well rise, within the next five years, to about £1.5tn.
In many ways, therefore, the recession will be where all the money goes. "There is a fundamental deterioration in public financing," says Redwood. "This is an economic crisis, not banking crisis." No one will be drawn on the total cost of everything put together, for the very good reason that it is almost impossible to calculate. They can only say, like Kirchmaier, that "It's big. One day, when we go back and do the numbers, we won't like what we see." What we do know is that we will be paying for it - in reined-in entrepreneurship, in lost livelihoods, in higher tax and public budget cuts - for generations.
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