John Redwood

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Resolving the credit crisis

Thursday, May 8 2008

By the Rt. Hon John Redwood MP

On the day of the recent local elections, the so-called “independent” Bank of England allowed its Financial Stability Report to be published and the line spun that the worst of the credit crunch was behind us. A truly independent Bank of England would have left such a publication for the day after the elections, to avoid being dragged into the political argument. It would have also insisted on a balanced presentation of what their long and serious report actually said.

The Bank of England is not as independent as Gordon Brown claims it is. The key members of the Monetary Policy Committee, which sets short-term interest rates, were appointed by Mr. Brown. It was Mr. Brown who, as Chancellor, set the Bank’s targets, and who changed Britain’s method of measuring inflation from the RPI to the CPI before the last election, making it easier for the Bank to meet these targets. This change had the happy consequence for Labour of keeping interest rates down.

Contrary to the spin, the Bank’s report does not make comfortable reading and shows just how persistent and deep seated the liquidity and valuation crisis in the banking sector has become. The Bank’s own measures of liquidity are summed up in an Index. This has fallen off a cliff and is at its weakest level since the market falls of 1998 and 2000.

Rather than the worst of the credit crunch being behind us, the report says that tight credit conditions can be expected to lead to more defaults and repossessions amongst borrowers, suggests that some of the losses are still to materialise, and states that there could yet be more bad news to come.

JP Morgan has suggested that 40,000 jobs in the City, the engine of British growth, could be lost due to the lending crisis. High street retailers are closing branches due to the knock-on effect on demand. House prices are headed for a period of stagnation or worse over the next few years, with first time buyers being further excluded from the market due to the banks’ reluctance to write more loans.

There has been a big difference in the way the government has handled the credit crisis compared to the American authorities. The Fed took the drought in the money markets seriously. They have cut taxes and made a big flow of liquidity available to ease the worst of the problem. They recently reiterated their determination to prevent a recession by cutting interest rates to just 2%.

The result of this should be some modest stimulus from the tax cuts, whilst the second half of the year will see more impact from the shift to cheap credit. At some point even the distressed housing sector will pick up, as it has already fallen about as much as could be expected. Some have said that this will be bad for inflation, forcing up interest rates once the crisis is over.

Yet the latest figures from the American economy do not suggest this will be the case. US productivity grew by 3.2% over the year ending March 2008. As people across the economy were working smarter, with modest wage and salary rises overall, costs were kept under control. Unit labour costs only grew by 0.2% for the year. This is hardly evidence of an inflationary lift off.

Our own authorities have been less dynamic. Initially, the government said there would be no bail-outs or help for the banks last September. When it became clear the credit crunch would mean more than a few lost bonuses for well-fed bankers, they started to panic. Mr. Darling has now taken to asking the banks to lend more and pass on interest rate cuts to their customers.

That they have failed to do so shows how much faith they have in Labour’s professed record of economic competence. The government’s scheme to offer £50 billion of near cash to the banks in return for some of their mortgage books was designed to reassure the markets. This should help alleviate the shortage of cash, but the public will be exposed to some risk until the crisis has passed and the transactions are unwound.

At some point the government needs to sell off the mortgages again and repay the borrowings which were used to fund the scheme in the first place. Moreover, it has come too late in the crisis. Had this money been made available last September there would have been no run on Northern Rock. That unhappy institution would not now be owned by taxpayers, shedding at least a third of its staff and fighting a legal argument over competition law with the EU, nor would it be running its business down and struggling to repay massive loans from the taxpayer.

The talk is now of bringing in further banking regulation. This might pander to the feeling that “this must never be allowed to happen again”, but it would be unwise. The truth is it was the detailed regulation of banking under Basel I that encouraged banks to put risks off balance sheets and securitise in the first place. Had the banks been left to their own devices to assess capital adequacy, they might not have gone so far in this direction, but as the regulatory sums allowed them more leeway this gave a sense of false security.

After all, no self respecting banker would be seen to have substantially more capital than the regulator thought was necessary. Although there are several regulatory changes that may have a role to play in bringing us out of the credit crunch, each one, if imposed too strictly and too soon, could make getting out of this mess more difficult.

Requiring more transparency from banks would be a good thing, but, in the present mood of insecurity and caution, a sudden rush to publish more information may fuel fears rather than offer reassurance. Requiring more regulatory capital to allow for the risks of tight credit conditions may be prudent in the future, but at the moment when banks are working hard to ensure proper balance sheet ratios, any added requirements would just delay the recovery.

There is a danger of relaxing the regulatory requirements in good times, fuelling a boom, and then demanding more regulation in bad times, tightening the squeeze. Even the Bank of England concedes that the new Basel II rules could exacerbate this problem. This should be cause for immediate action.

The government should take the initiative, recognise that the tripartite system they set up mishandled the Northern Rock crisis, and reinstate the Bank of England as the chief controller of commercial banks and the manager of money markets. Gordon Brown’s “reforms” in the late 1990s took away banking supervision and government debt management from the Bank of England. Far from making the Bank independent, this took away an important source of knowledge and understanding of money markets. These two jobs go together and it is difficult to do one before the other.

The UK authorities also need to recognise that, for the moment, the main aim should be to prevent a recession instead of fighting inflation. Although it was the Monetary Policy Committee’s lax approach to credit which underpinned the boom of recent years, they need to consider ways of making credit flow more easily lest they now lurch from boom to bust by being too tough on borrowers.

The price increases we are seeing are either of the government’s own making - as a result of higher taxes - or outside its control, as increased demand from India and China, the flooding of rice fields in Asia, and the diversification of crops for biofuels have all led to food, energy and raw material prices increasing dramatically over the last six months.

What the credit crunch has done is reframe the debate on tax and public spending. People now feel their incomes squeezed and need some form of tax relief to pay their bills. They are no longer inclined to believe Labour’s line that good public services require higher taxes, nor are they likely to be scared by claims that tax cuts would mean a “black hole” in public finances. Now they see that Northern Rock and the government’s mishandling of the crisis has created a bigger black hole than that which they ever falsely alleged the Conservatives would create.

John Redwood is Member of Parliament for Wokingham. His commentary on Northern Rock and the credit crisis can be found on his website www.johnredwood.com.