Anew type of protectionism is stalking the world—financial isolationism. It’s fairly subtle. No trade or tariff barriers are erected. But it still threatens to deepen the economic downturn. British Prime Minister Gordon Brown has rightly been banging the drum about the dangers.
Financial isolationism involves banks retreating behind national frontiers. It is easy to see how this can happen. National governments are pouring billions into local banks. They want to see them increasing—or at least maintaining— lending. But many of the banks are still in deleveraging mode.
The easiest way to reconcile the political pressure to lend more at home with the financial imperative to reduce leverage, is to lend less abroad. Banks can cut the overall size of their balance sheets without disappointing their political masters.
Raising an alarm: British Prime Minister Gordon Brown has been warning against the dangers of banks retreating behind national frontiers. Pascal Lauener / Reuters
But if every country’s banks engaged in such a policy of national retreat, the collective effect would be self-defeating. Even if national banking champions kept lending constant, the loss of credit from foreign banks—under pressure to keep lending in their own home markets—would shrink the overall pie.
In theory, the exercise of simultaneous withdrawal from the big world could be harmless. The retreats behind national frontiers would cancel one another out. In practice, the effects would be terrible.
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First, the retreat to national frontiers wouldn’t be even. Some countries—developing ones reliant on foreign banks and those with big current accounts to finance—might suffer extreme credit droughts.
Second, it would be harder for banks to spread their risks. A bank with all its eggs in one giant national market might become more risk-averse. If every bank in the market is in that position, the whole market will become more cautious about lending—not what is needed today.
Finally, without foreigners, national markets would be dominated by a smaller number of large players. That would undermine competition and reduce choice for consumers of financial services everywhere.
The politics are tricky. Why should taxpayer dollars go to subsidize foreigners? The answer depends on whether there really is a foreign subsidy going on. Take Citigroup Inc. It has received a huge capital injection from the US, but that is needed to refill its depleted coffers at home. Its foreign subsidiaries are well capitalized.
For banks with struggling foreign subsidiaries, the choices are more stark. If the parent bank is unable to inject more capital—and its own government is unwilling to—the local government will be asked for aid. The normal response will be to give aid, but to nationalize the local subsidiary.
This has already happened with Fortis’ Dutch operations— and it may happen with some Eastern European banks owned by Western ones. But such hard cases make bad principles. Financial isolationism is a trend that should be strongly resisted.