The world’s governments are now caught in a bind. They are being forced to choose between depositors and investors — to protect one lot and screw the others.

In the midst of crisis, there is no real choice: they must protect depositors first. Each nation’s economy relies upon public confidence in the financial intermediaries, so they must, of course, guarantee bank deposits to stop the international bank run that has been building for the past month from overwhelming their central banks.

There is simply no choice about this, especially after Ireland became the first to guarantee bank deposits two weeks ago. The Australian government acted correctly yesterday in moving ahead of the meetings taking place in Washington and the Elysée Palace. Why others are dithering is hard to fathom; perhaps they are worried about the consequences of the next step.

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The next step is to recapitalise the system. Deposit guarantees won’t be enough on their own because the underlying problem is solvency, not liquidity, and many of the world’s banks have to be recapitalised because of the losses from poor lending decisions.

As we have seen several times already, when banks are ‘rescued’ the equity is either severely diluted or wiped out.

This was the problem with US Treasury Secretary Henry Paulson’s $US700 billion bailout plan: it would have bought bad assets from the banks and left the shareholders more or less untouched. That led to accusations that he was just protecting his old mates on Wall Street (he had been chairman of Goldman Sachs).

That’s why Congress revolted to begin with, and why he has now had to abandon that plan and move instead towards direct injections of equity capital – at very reduced prices that will dilute existing shareholders.

Those existing shareholders are pension funds. In the process of recapitalising banks, governments will be wiping out the retirement savings of many citizens.

Those savings have already been hugely diminished by the 40 per cent fall in the stockmarket already.

And while the savers who have their money in cash bank deposits will now be protected, those who have had faith in long term investments in company shares, especially banks, are about to be thrown to the wolves.

Apart from the misery and disastrous loss of faith in long term investing this will cause, it will mean governments will have to make up the difference through welfare payments.

The past 20 years has seen a vast global move towards the privatisation of retirement savings in anticipation of the baby boom bulge producing a big increase in demand for old age welfare. The aging of the population has been a major policy issue everywhere.

Up to 2008, the privatisation of retirement savings has been a huge success because of the virtually continuous bull market in stocks. The policy of shifting retirement savings risk to individuals, and away from governments and companies (defined benefit pensions are now extinct), has been a great success and vote winner, because of the big gains that have been in the boom.

Superannuation balances around the world have grown rapidly and retirees have more often been able to fund themselves and not rely on the state.

Now those who have retired and left their funds in the stockmarket to provide annuities, and those who are about to retire, are in serious trouble. Many will be forced back onto the state.

This will only get worse as banks are recapitalised and existing equity in them is wiped out.

And although Australia’s banks are among the best capitalised in the world, they represent a bigger fraction of Australian investment portfolios than most in the world and their share prices have already fallen a lot.

Moreover if you think our banks are immune from loan losses, remember that Australia has some of the world’s biggest corporate basket cases: Babcock & Brown, Centro and Allco. All of the Australian banks are well represented.

At the moment there is a kind of Mexican standoff in which the banks are standing in the saloon with guns pointed at each others’ heads. No one wants to pull the trigger.

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Peter Fray
Peter Fray
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