THE British Government should allow every distressed bank to go bankrupt and set up a fresh banking system under temporary state control rather than cripple the country by propping up a corrupt edifice, the Nobel Prize-winning economist Joseph Stiglitz believes.

Professor Stiglitz, the former chairman of the White House Council of Economic Advisers, said Britain should let the banks default on their vast foreign operations and start afresh with a new set of healthy banks.

“The UK has been hit hard because the banks took on enormously large liabilities in foreign currencies,” he said. “Should the British taxpayers have to lower their standard of living for 20 years to pay off mistakes that benefited a small elite?

“There is an argument for letting the banks go bust. It may cause turmoil but it will be a cheaper way to deal with this in the end. The British Parliament never offered a blanket guarantee for all liabilities and derivative positions of these banks.”

Professor Stiglitz said the Government should underwrite all deposits to protect Britain’s domestic credit system and safeguard money markets that lubricate lending. It should use the skeletons of the old banks to build a healthier structure. “The new banks will be more credible once they no longer have these liabilities.”

He said the City of London would survive the shock of such a default because it would uphold the principle of free-market responsibility. “Counter-parties entered into voluntary agreements with the banks and they must accept the consequences,” he said.

But such a drastic course of action would be fraught with difficulties and risks.

It would leave healthy banks in an untenable position since they would have to compete for funds in the markets with state-run entities.

The British banks have nearly $US4.5 trillion ($A7.08 trillion) of foreign liabilities.

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