Monday, 17 September 2007

The least worst option


Northern Rock does not not deserve a bail out but not giving them one could be a recipe for disaster

I wasn't planning to blog while I was at conference but I've changed my mind because of a rather extraordinary sight, I saw this morning. Out hunting for an internet cafe, I passed the Brighton branch of Northern Rock and one of the longest queuses I have ever seen. I had initially opposed the bail out of private bank with public bank but that sight has changed my mind. It brought home to me the danger of financial panics and how important it is we avoid them.

Northern Rock does not deserve a bail out. It took a gamble and lost. Rather than relying as most banks do on a combination of money from individual depositors and money borrowed from other banks, Northern Rock relied almost entirely on the later. This worked fine so long as interest rates in the inter-bank lending markets were low but when the credit crunch pushed borrowing rates up it found itself in trouble. Being so relieant on one source of finance was a risky move and if Northern Rock's shareholders do not pay the price when gambles such as this backfire, then that will have no incentive to be careful how they do buisiness. Economist call this a 'moral hazard.'

However, the queue has made me doubt this logic. We have hundreds of people pulling there money out of a perfectly safe bank. Not only has Northern Rock been declared safe by the bank of england but it has also been given access to the worlds biggest overdraft courtesy of the bailout. These withdrawls are pure panic.

My concern would be that if Northern Rock were to collapse, then people would panic and begin to loose confidence in the banking sector as a whole and we could start to see runs on other banks as well. This could become a particular problem if some of the other smaller banks that have run in trouble also collapsed. This is perhaps unlikely but the result would be so disastrous not just for the UK but perhaps for the world economy as a whole. We should do everything on our power to avoid it, including rewarding careless companies.

1 comment:

a radical writes said...

Its the same old story thats happened in other credit collapses, except this time we're lucky that this credit collapse has been limited to a relatively small sector and not the entire savings sector (although a significant part admittedly). Thankfully because of this the government and bank of England is able to bail out companies and consumers out of such a situation without causing any major inflationary damage to the economy. However, the same will not be able to happen twice, a line has to be drawn. It is the simple but important message John Maynard Keynes gave in his writing which was unfortunately forgotten by many of his Keynsian successors that if you continue to invest in companies and bail them out at times when it is unneccessary to the economy as a whole then you will create innefficiency and inflation. The Labour government has done this not for economicly sound reasons but more for political ones, we should hope that this does not become a continuing political trend.