Today was an historic moment. The RBS and its barely comprehensible loss signaled the end of an era. The days when finance was the engine of the UK economy are definitively over. The UK banking sector has become the 21st century equivalent of coal mining; over-staffed, over-paid, and profoundly unproductive.
When the RBS announced that loss, it shot a fatal arrow straight into the heart of the UK banking sector. This loss is equivalent to 2 percent of GDP. Think about that; one bank in just one year lost 2 percent of national income. Moreover, the bank's balance sheet is almost as large as the UK GDP. This is a bloated and obese behemoth. It can not survive in its present distorted condition. Everyone knows it and that is why the share price collapsed.
What is true of the RBS is also true of all UK banks. They are too big; they employ too many people and their funding model is unsustainable. No amount of government intervention can negate that reality. The government may have access to our collective handbag, but we as a nation simply don't have enough money to cover up the losses of our banks.
So what happens next? The government will continue to prop the banking system with liquidity. Whatever Brown and Darling might say in public, they now have the minimalist objective of preventing total collapse. It is simply inconceivable that lending could return to the 2007 levels. The heady days of near limitless credit growth have gone. The government would be doing well if it simply avoids another financial sector meltdown.
The UK banking system is going to have to shrink. The only question is whether this will be an orderly process. As the system goes into terminal decline, asset prices are going to adjust to a new and much lower equilibrium. Houses, commercial property, art, and football teams are all about to get a lot cheaper. This adjustment will be very unpleasant.
What about the real economy? This too will adjust, and it will be painful. The bulk of the adjustment will be in financial services, which has just begun to shake out all that value-reducing labour that created this appalling banking crisis. Currently, the sector employs about 6 million people. Don't be surprised if that number falls by half.
Over time, these people will find new and productive forms of employment. Wage rates will adjust downwards, and the UK manufacturing sector will slowly revive after years of neglect. The UK economy will again start to make things. Eventually, the economy will start to grow and we will recover from the terrible wounds inflicted upon us by our banks.