For obvious reasons, I've been thinking a bit about whether a national loan guarantee scheme is really a good idea. My current inclination is to think it's a terrible idea. I want to explain to you why. However, the question isn't completely straightforward, and I'd be interested in reading any counter-argument people have. Even the process of writing down my thoughts may help me.
There is, of course, a discussion to be had about how much the government should charge for its loan guarantees, and whether, if it charged a rate that reflected proper actuarial assessment of the risks, the price would be so high that no-one would take them up. That's an important discussion in its own way, but it won't feature in what I shall discuss. My discussion here concerns the principle of such a scheme, not the detail of how to implement it.
We're told that many perfectly sound businesses currently can't obtain perfectly normal loans. As an economist, I'd typically be very suspicious about a claim like that. The thought goes something like the following: If the business is really as sound as you say, and the loan really as good a prospect as you suggest, then there must be an interest rate that could be charged for a loan at which the lenders of the money would expect to make a good return and the firm could pay whilst still being profitable. So in a competitive market, surely there would be someone out there prepared to lend the money?
We should ordinarily pay close attention to arguments of this sort. But in current circumstances there is an extra twist that makes the argument more difficult. For loans are rarely made directly from those that have saved money to those that want to borrow. Instead, loans pass through a middle-man, an "intermediary" such as a bank. Well, normally that doesn't change much in the argument except to significantly cut the costs of setting up and servicing the loan. Under normal circumstances, the bank would assess the borrower and the borrower's project for which she wanted the loan, and decide whether, at a given interest rate, the return would be attractive and what the risk was that the borrower would default. But at the moment there is an added dimension (actually there are several, but I'll just stick to the one here). The bank must think about not merely the risk that the borrower defaults and hence the return on the loan is poor, but also whether, if loans of this sort are made, what is the risk that the bank will go bankrupt. This makes the decision more complex, and might mean that a loan that should be a reasonable bet considered narrowly (focused just on the risks and returns from the specific loan) will not be a reasonable bet when considered as part of a wider policy (many such loans going bad at once might wipe out the bank).
It's easy, of course, to state that there are "distortionary" intermediation problems of this sort, but difficult to prove. It's all very well declaring that businesses that banks won't provide loans to are actually perfectly sound, but do we really have the information that allows us to say that? Perhaps the bank's risk analysis teams are rightly more pessimistic than our politicians, and in fact almost nobody should be borrowing money for anything at this time?
There's not nothing in this caveat, but let's suppose for now that perhaps there are some intermediation problems (problems with the intermediaries such as banks). Where does that get us? We already said that the original argument (that if you don't get a loan it's because the Market thinks you aren't a good risk) doesn't normally get into the complexity of intermediaries because it doesn't need to. And there is still capital around. Some companies continue to make profits; individuals are saving more than in the recent past. So there is still loan capital available. So even if the bank wouldn't lend businesses money, there must be the possibility, in principle, of just borrowing it directly or borrowing through some newly established bank?
Well, yes. But setting up new banks involves time and transitional cost, and in the meantime intermediaries enormously reduce the costs of setting up and servicing loans. So, of course!, there is a price at which direct saver-to-borrower loans could be made, but there is no guarantee that the interest rate would be remotely similar to that that one would have expected to be charged by banks.
So, whilst the intermediaries (banking) sector is in trouble, it might become in some sense "artificially" expensive to borrow (by which we mean that borrowing would be at higher interest rates than would be charged by competitive new banks if they could be summoned into existence overnight).
Fine. I agree with that. And I have previously recommended policy action in response. Since intermediation through banks is temporarily impaired, I have recommended that the government act as an intermediary (a middle-man) instead. The way I said to do that was for the government to lend money to workers (through temporary income tax cuts) and businesses (through corporation tax cuts) and borrow that money directly from savers (through selling government bonds). (Note that this would indeed be "lending" by the government since these tax cuts would have to be paid bank in higher taxes later.)
But a loan guarantee scheme is a bit different. At first sight, it may not be obvious quite how different. After all, perhaps we could imagine an unconditional national loan scheme - any loan provided by a bank would be guaranteed by the government. That is all-encompassing, rather like a tax cut, and doesn't commit the government to becoming involved in the detail of loans (deciding who should and shouldn't receive them) - or at least no more involved in the detail than it already is as the owners of much of the banking system. Obviously there would be considerable problems if we introduced a scheme whereby the government decided who received loans and who didn't. We wouldn't want the only businesses in the country to be those the government actively approved of!
But could this really be avoided through a national loans guarantee scheme? I suggest not, for two reasons. First, the political problem. In due course, there will be a formerly convicted paedophile, or a former BNP member, or a notorious homophobe, or a religious nutcase who has a perfectly good, smart, money-making business scheme that warrants a loan. The Daily Mail will be tipped off by a horrified bureaucrat, and the newspapers will be asking "Is this what we pay our taxes for - so we can lend money to people like this?" I don't believe it would be politically sustainable for the government to be disinterested in who received funds.
Second, there is an incentives problem. If loans are guaranteed, then the bank has little incentive to verify properly how sound the borrower's business proposition really is. [Those advocating loan guarantees typically suggest that the government should guarantee only a portion of the loan - say, 80% - so that the bank would retain incentives to check. But 20% exposure is only one fifth the incentive to check, so though such an "excess" (like an excess on your motor insurance) of course has some effect, the core change-to-incentives problem remains.] The result will be that, unless the government checks carefully which loans it guarantees (and hence becomes sucked into deciding who receives loans and who does not) people will be loaned money to set up poorly organised and conceived businesses. These bad businesses will, during their unpleasant demise, attract customers away from perfectly good businesses, whilst also harming their suppliers. So the profitability of good businesses will be undermined by the bad ones. An arms-length loan guarantee scheme would risk eventually undermining the proper market functioning of most of the economy. To avoid this, the government could not be disinterested in who receives funds.
So, by these two mechanisms, a national loans guarantee scheme would, perhaps gradually but inexorably, suck the government into more and more involvement in determining which businesses should receive loans and which not. To add to the nationalisation of the banks, the provision of intermediated capital would come under even closer State control. Once the State had taken control of intermediating capital in the economy, it would be incredibly difficult for it to withdraw itself. Apart from anything else, the fact is that private sector banks would almost certainly not lend to the same people that the government would. So withdrawal from State control of banking would mean a significant structural change in the economy - in other words, we would need to suffer a great big recession at the point at which government withdrew. It would take a terrible crisis for the government to be prepared to take the political damage of such a recession. So State control of lending would be with us for a very long time.
In contrast, the elegant solution here remains for the government (if only it had a credible plan for rectifying its budget deficit in due course, which the current lot do not - hence the travails of the pound) to act as a scatter-gun intermediary, not deciding who does and does not receive funds, but instead providing funds to everyone through tax cuts (in the case of businesses, through corporation tax cuts). Even as a second-best solution I am highly doubtful of the merits of a national loan guarantee scheme. Everyone else seems to be in favour, so doubtless I am missing something (and I shall be most interested to read your remarks and counter-articles). But at present, I am inclined to think a national loan guarantee scheme a terrible idea - the next ratchet for State control.
