To understand what is going on in the current financial crisis, and to consider who would shoulders the burden of alternative solutions, it is necessary to have a basic understanding of banks’ balance sheets. The assets of a solvent bank – i.e., its loans – will be more than its liabilities, with the difference between its assets and liabilities consisting of its ‘reserves’ and shareholders’ funds. A bank’s reserves can be thought of simply as a deposit account that the bank has with itself, which grows when the bank makes profits and shrinks when the bank makes losses. Its profits normally come from charging borrowers more than the sum it pays out in operating costs and in interest on deposits. But it can also make profits if it enjoys capital gains on assets that it owns, such as shares, government securities, or foreign exchange.
When a bad loan is written off, or some other form of capital loss is suffered, the bank’s assets are written down by the amount of the loss, as are its reserves. A bank is insolvent when the losses that have to be written off are bigger than its reserves. The shortfall in reserves means that the bank can only pay its depositors a fraction of their deposits. If the depositors panic and try to withdraw their money en masse, the bank may then have a liquidity problem too, for it will not be able instantly to liquidate its loans and it may have trouble borrowing funds from elsewhere to repay its depositors. In the early phase of the Global Financial Crisis, the problem was more a liquidity problem than a solvency problem, for banks got nervous and became unwilling to lend to each other at a time when some institutions needed to pay out panicking depositors or simply refinance existing deposits. But increasingly the solvency issue is threatening to drive the financial system into meltdown.
When a bank is insolvent, writing down the value of deposits by the value of the shortfall does not fully solve the problem even if it does not cause further loan defaults due to depositors being unable to meet their financial obligations after having their deposits marked down. Such a writing-down of deposits will still leave the bank without any reserves, so it either needs an injection of new shareholder capital or a period of sustained profits to restore its reserve position. To the extent that banks in general are worried about growing insolvency risks, we may expect to see them increasing the ‘spread’ between their loan charges and rates of deposit interest and hence their retained profits. If this is going on, banks on the marginal of survival may likewise start to generate operating profits and start to accumulate new reserves. This way of staving off disaster involves the burden of adjustment being borne by the banks’ borrowers, not by their depositors. If bank margins are increased prior to loan defaults, shareholder capital may not be wiped out and depositors will not have their deposits written down. But pushing the burden of dealing with previous bad lending decisions on to the borrowers may increase the scale of defaults.
Because of this, policies aimed at preventing the collapse of banks have tended to involve the banks being provided with financial assistance or ensuring that their debtors do not default. If a government nationalizes a failing bank and recapitalizes it, the bank’s reserves are restored and a write-down of deposits is avoided. However, instead of having their deposits written down in value, members of the non-bank private sector still end up suffering a reduction in their wealth if the government borrows on financial markets to pay for bank recapitalization and then increases taxes to service and eventually repay these loans. In terms of the banks’ balance sheets, assets are reduced by the amount of the loan write offs as are reserves (to the extent that loans are indeed written off) but so, too, deposits. In essence what happens with deposits is that some deposits are used to buy government debt, with the money received by the government then ending up in bank reserves. As the loans to the government are serviced and repaid, the bank deposits of those who bought the government bonds are replenished and those of the rest of the public are reduced. The rest of the public’s bank deposits end up being lower than they otherwise would have been due to increases in taxation or cuts in public spending. This, in essence, is what has happened in Ireland. The masses end up paying for the incompetence and/or opportunism of the bankers.
From a Keynesian standpoint, the Irish solution looks crazy if implemented at the level of the world financial system as a whole. There is no need to impose burdens on ordinary people in order to revive the financial system, for governments can simply ‘print money’ (aka ‘engage in quantitative easing’) in order to buy up failed banks and recapitalize them. Under quantitative easing, government debt grows and the debt does not end up in the hands of the private sector but on the assets side of the reserve bank’s balance sheet.
The Keynesian solution is only open to governments in command of their own currencies, such as the US and the UK. It is not an option for Greece and Italy, since they are members of the Euro zone, and neither is their problem one of bank solvency within their countries. Rather, the problem is of Greece and Italy is their inability to service or refinance their own levels of borrowing, which threatens the solvency of banks in other countries. The governments of the latter, such as France and Germany, are addressing the problem by trying to prevent sovereign debt defaults – i.e., by agreeing partially to refinance the problem deficits so long as they are also partly reduced by austerity measures being imposed on the populations of the debtor countries. In this way, the populations of corrupt, poorly-managed economies are given a strong message that they had better elect better governments that will reform these economies to ensure such problems do not recur; they do not get off largely without penalty. Their fate is in sharp contrast to that of the least credit-worthy of the US sub-prime mortgage customers, who walked away with their new furnishings and cars after defaulting on negative equity home loans that they had used, while the market was rising, as if they were getting money out of an ATM.
If Greece or Italy were to leave the Euro and default on public sector debt obligations, their residents would still end up suffering reduced real incomes, for their new currencies would fall in value against the Euro and other currencies, raising the prices of imported goods. (Residents of these countries would therefore be wise to hold their current Euro wealth as cash rather than as electronic bank deposits for as long as the risk of exit from the Euro is present.) But they would have a bigger chance of avoiding unemployment and lost output, and part of the problem would then be pushed over to the banks and, ultimately, governments and residents of other countries. The remainder of the Euro zone, and other countries in which bank solvency was jeopardized by exposure to Greece, Italy and their like, would then face a choice between the Irish solution and a more Keynesian strategy based on quantitative easing and bank nationalization. If they were foolish enough not to go for the latter, Keynesians would surely hope that an Irish-style solution would be modified by ensuring that the burden of the austerity measures fell on the rich (especially bankers), whereas in the Irish case the bankers and elite public servants were insulated from the cuts and tax increases. If the less well-off have a higher marginal propensity to consumer than the rich, a more egalitarian version of the Irish solution may also have less adverse implications for aggregate demand.