By Paul Amery

Published: July 22 2008 19:59 | Last updated: July 22 2008 19:59

The state interventions over the past 10 months have not been without their confusions and contradictions. Chancellor Alistair Darling’s sudden commitment to underwrite all of Northern Rock’s deposits, a move that would have exposed the UK taxpayer to massive liabilities if repeated across the banking sector, has now been cut back to a planned deposit guarantee of £50,000 per person per bank. At the FSA a much-publicised investigation into rogue short-sellers and market manipulators was launched after a sharp fall in the share price of HBOS in April, only to be quietly dropped a couple of months later, no culprit having been found. And of course Mervyn King, governor of the Bank of England, made a famous speech last autumn in which he declared that “the provision of large liquidity facilities penalises those financial institutions that sat out the dance, encourages herd behaviour and increases the intensity of future crises” – only to try to save Northern Rock a day or two later by offering exactly such support.

One can only hazard a guess at the state of mind of the officials staffing the country’s regulatory authorities following these actions and public statements. But their difficulties, while often made worse by poor presentation and the frequent impression of panic, are the result of an intractable contradiction at the heart of policy.

This contradiction is set out clearly in a report (“Financial stability and depositor protection”) recently issued by the UK’s tripartite regulatory authorities. Section 1.27 announces that: “It is important for market discipline that firms – including banks – should be allowed to fail” but then goes on to add that “the potential impact of a bank failure on consumers and financial stability means that a key objective of the authorities is to reduce the likelihood that individual banks face serious difficulty”. In other words, banks should fail in theory, but we will not let them do so in practice.

The result of this explicit safety net has, unsurprisingly, been market indiscipline by the bankers. From increasingly reckless lending policies to extravagant employee compensation schemes, costing over 50 per cent of revenues for some investment banks, the party has been long and furious. But the benefits of this government policy of financial sector interventionism must surely be outweighed by the costs; from a rapidly increasing share of public expenditure to the increasing likelihood of social unrest, as bankers are granted state support that no other part of the private sector enjoys.

While deposit insurance has become a staple central bank policy worldwide since its introduction in 1934 in the US, it is easy to forget that regular bank failures in the 19th century did not prevent economic growth. Indeed, research shows that US banks were better capitalised and more stable under the free banking system – the regime prior to the creation of the Federal Reserve in 1913 – than they are now and particularly since the “too big to fail” doctrine was explicitly pronounced in 1984. To give another example, a wave of bank failures in Russia in 1998 neither crippled the real economy nor prevented a subsequent boom.

The UK authorities’ latest moves give little confidence that anything will change. The chancellor’s extension of deposit insurance was underwritten by the taxpayer, with pre-funding of the scheme by banks ruled out. Neither have the authorities demonstrated any control of the remuneration or dividend policies of the institutions that they are seeking to save.

But for the long-term health of the economy it is vital that the authorities remove the last great socialist industry – the banking sector – from its life support system. This would do much to level the economic playing field and damp the debilitating boom-bust cycles to which our country is so prone.