30 January 2009
Gordon Brown claims the Conservatives are the ‘do nothing’ party. But it makes sense to promote saving over lax lending and spending
Last year we heard that Prime Minister Gordon Brown had ‘saved the banks’, yet 2009 has begun in an alarmingly similar fashion to the end of 2008. Bank share prices are under pressure once again and the government is living up to its ‘do something’ reputation with a range of new measures to kick-start lending. When will the bail-outs end? When will the economy recover? How much will governments have to intervene?
The dominant political theme is that significant intervention is the only option, given the pre-Christmas boost in the polls enjoyed by the government following the first bail-out. With the electorate astonished at the size of the banking bail-outs and the speed with which the recession has taken hold, there is an urgent sense that something needs to be done.
As the mood becomes ever more desperate, the government has made political capital by portraying the Conservatives as the ‘do nothing’ party. This strategy has struck an emotional chord, with the prime minister making reference to the parable of the Good Samaritan, and refusing to walk on by as the economy deteriorates.
Brown’s biblical reference was prompted by the Archbishop of Canterbury’s remarks that the fiscal stimulus package was ‘like the addict returning to the drug’. The Conservative response builds on that theme. Leader David Cameron and shadow chancellor George Osborne have frequently pointed out that it was lax management of the public finances that got us into this mess – and further spending shouldn’t be used to get us out.
Far from ‘doing nothing’, they have proposed a number of measures to restore the flow of credit. Many of these, including the National Loan Guarantee Scheme, have been adopted by the government to focus on restoring liquidity. They argue that fiscal irresponsibility only stores up problems for the future and is simply a replication of the ultimately unstable policy behind the ten-year boom. Therefore the country needs to change tack, and reconnect with a culture of saving, rather than one of spending.
The Tories have also emphasised the need for a new approach to financial discipline across government, claiming that, under Labour, civil servants have been encouraged to ‘shovel money out of the door as fast as possible’. Osborne, speaking to the Institute of Chartered Accountants in England and Wales, said a Conservative government would put more emphasis on the role of Whitehall finance directors and would place a new duty on civil servants to spend taxpayers’ money wisely.
The government would argue that this crisis is too severe to favour the long-term outlook over improving the economy in the short term. Hence the VAT cut announced in the Pre-Budget Report. In theory, cutting consumption tax should boost spending as it is directly focused on encouraging shoppers to get into the stores and spend. Two factors undermined the effectiveness of this policy: first, stores were already discounting stock by many more multiples than the 2.5% VAT cut; secondly, the government pre-announced tax rises to hit consumers after 2010, encouraging the electorate to save today’s gains to prepare for tomorrow’s tax hikes.
With the economy still in the doldrums, it seems that this policy failed to provide a much-needed boost to confidence. It has also added to the worsening state of the public finances, with the budget deficit predicted to reach 8% of gross domestic product and government borrowing over the next six years set to rise by over half a trillion pounds. This eye-watering amount could further undermine sterling: its value has already fallen by almost one-third since the onset of the credit crunch in August 2007, with the decline accelerating since the bank bail-outs began.
Therefore the claim that ‘do something’ trumps ‘do nothing’ must be balanced by considerations over the future ramifications of government action. The Conservatives have drawn attention to the potential tax bombshell and debt burden that will fall on future generations. Even in the shorter term, the UK economy might find it difficult to fund itself as international investors decide it is too risky to invest in a nation that is unable to keep its public finances in check. As American investor Jim Rogers said on January 20: ‘I would urge you to sell any sterling you might have, it’s finished. I hate to say it, but I would not put any money in the UK.’
If investors decide to desert the UK, that would raise the cost of issuing government bonds, trigger a run on the pound and potentially lead to a UK government default. This raises the spectre that, once again, a Labour government might have to call in the International Monetary Fund. Sadly, even such a doom-laden prophecy as this cannot be ruled out.
Despite the focus on such worst-case scenarios, there are reasons to see a chink of light amid the gloom. Persistent references to the Great Depression should mean that policy makers do everything in their power to avoid it. The chair of the Federal Reserve, Ben Bernanke, is an expert in that period of economic history, and he even wrote a speech in 2002 that outlined exactly what he would do if a credit-crunch deflationary period were to occur. The fact that such a roadmap exists is in itself cause for optimism.
The UK authorities have suffered slightly from their failure to have such a plan, but with the US having entered the recession first, they can learn from the actions of their partners across the pond. Indeed, the latest bank bail-out plan owes much of its detail to the measures taken by Citigroup and Bank of America at the start of 2009. There had been talk about the creation of a ‘bad bank’, which would pick up all the toxic assets from the country’s banks, remove them from balance sheets, and free up the banks to start lending again.
The credit crunch began because of the existence of these hard-to-value complex loans. When US home owners began to default on their debt, and house prices went into free fall, no-one could be sure how much these loans were actually worth. And if no-one wanted to buy them, were they worth anything at all? Fundamentally, there is a value to these loans: the houses upon which the mortgages were granted have a value, but until the housing market stops falling it is almost impossible to know what it is. In this circumstance, only the government can step in and quote a price at which they would buy these securities. That sets a floor under the price of the assets and the recovery process can begin.
However, after all the talk of a ‘bad bank’, the government has settled for a swathe of measures centred on a large insurance scheme. Both ideas aim to draw a line under the ever-increasing losses from toxic debts and non-performing loans to free banks’ capital and encourage them to lend. The main difference between the insurance approach and the ‘bad bank’ is how quickly losses are revealed. With the ‘bad bank’, this is immediate as the government finally puts a price on debts that have remained difficult to value since the market in such securities evaporated. In the insurance scheme, the government guarantees losses up to 90% in exchange for an upfront premium. The premium will vary from bank to bank, and from asset to asset. The benefit to the government from such an insurance scheme is that they will receive something upfront, while the ultimate payout day might never materialise.
Politically this is a much easier sell, but economically it might slow down the healing process. As Keynes was forever pointing out, a lot depends on crowd psychology. The government hopes that the very establishment of the insurance scheme will kick-start lending and halt the slide in asset valuations. That should mean that the insurance is never called upon – and as sentiment improves, so the need for the insurance itself will diminish. The government has certainly filled the deck with all the aces that it can: guarantees on mortgage-backed securities and for new corporate lending should restart those markets, helping to unlock the credit markets and halt the slide in the securities that are covered by the government insurance scheme.
But the risks are high. We are at the beginning of a protracted recession. The risk of corporate defaults is high and rising. This increases the likelihood of large losses for the taxpayer. The insurance scheme has to improve lending and halt the slide in asset valuations before the economy lurches further down. Otherwise the guarantees will become ever larger in size, and more money will disappear down the black hole that the banking system now seems to represent.
By opting for the insurance scheme, the government has ducked out of owning up to the losses currently sitting around the system. It might be that these losses never need to be announced, the insurance is never called upon, and the voters can remain safe oblivious of the extent of the problem.
Given that sentiment is such a large part of the persistence of this crisis, perhaps this might be a wise psychological strategy. But ignorance is not always bliss. In this climate of financial fear, leaving the bad debts still out there and unresolved could simply prolong the problem. We could miss the chance to break out of the vicious cycle of bad debts and falling asset prices. Indeed, it’s ironic that the government’s insurance scheme is really a huge version of the kind of derivative that has been blamed for causing the credit crunch. The credit default swap market was created precisely to trade insurance in the event of a bankruptcy. It is also ironic that this government-backed CDS is being set up to increase lending, particularly in mortgages – the other culprit behind the economic crisis.
This poses another question about the response to the crisis: from a big picture perspective, are we just setting ourselves up to fail once again? Lax lending rules got us into this mess, but the government is taking drastic action to force the banks to restore lending to 2007 levels. Poor risk management decisions have resulted in huge losses for the banks, but their futures have been guaranteed. There is a sense of deep injustice that bankers made large amounts of money when the going was good, but now that the party is over, everyone else has to pay the price.
Regulation needs to change to address this injustice, but not at the cost of crippling the innovation and deregulation that gives us 24-hour access to our bank accounts, or to buying our family home. Banks are the bedrock of our economy – the veins through which money flows. It is clear now that they are the system, and therefore cannot be allowed to fail. It is now also clear that this creates a perverse incentive structure, whereby big risks can be taken in search of large profits, with any potential losses picked up by the taxpayer.
Regulators must ensure that the interests of depositors and bankers are one and the same. Banks are likely to become the new utilities: slow, simple, strong institutions that provide basic banking functions. Complex derivatives, structured high-interest products and securities can then be created by boutique investment houses, which would still be regulated, but not pose a systemic risk. These organisations can then be allowed to go to the wall without bringing the house down, ensuring that their management think twice about the credit they are lending and the products that they are selling.
Beyond the banking sector, we need to think about how the crisis will change the behaviour of all of us. We had all become part of a system that believed houses could provide our pension; that debt was a good way to finance the accumulation of material goods; and that we need never worry about boom and bust.
Gordon Brown must be wishing he had never laid claim to ‘abolishing boom and bust’, as his words get thrown back in his face at Prime Minister’s Questions each week. David Cameron is now building on the theme that the Labour Party failed to ‘fix the roof while the sun was shining’, by pointing out that both governments and individuals must now adopt a more responsible stance. His first speech of the year indicated that we must inculcate a culture of ‘save, save, save’ rather than ‘spend, spend, spend’. Saving and prudence – once the hallmarks of our previous chancellor and current prime minister – are indeed valuable virtues when preserving the stability of the economy. The government needs to lead by example, and not live beyond its means.
It is said that whatever doesn’t kill you will make you stronger. Despite the doom and gloom that permeates the January air, it is just possible that Britain’s economy will emerge more resilient, more balanced, and more stable than before.
Avoiding the financial icebergs
We have heard numerous accusations from the Conservative Party that the government has been living beyond its means. This week, it launched a detailed attack on the government’s profligacy and waste, in the proposal It’s your money: a new plan for disciplined spending in government. The ideas focus on changing the way in which civil servants are rewarded, and how they are held accountable.
The most practical policy recommendations within the document focus on placing clear details of government expenditure on the internet to improve transparency, and writing into employment contracts of senior civil servants that they have a fiduciary duty to provide value for money.
A range of other measures are proposed, based around ideas adopted from the private sector: that the finance director should be promoted to second in command after the permanent secretary, and that more civil servants should be given training in finance. The report points to the fact that, until recently, six departments, currently controlling a combined budget of £45bn, had no board-level finance director; and that less than 1% of the civil service have a financial qualification.
Given such facts, the Conservative proposals appear laudable. Changing a culture, however, will take more than just emphasising the importance of financial discipline. Shadow chancellor George Osborne acknowledged this, commenting that ‘it will be like turning around a supertanker’.
As this crisis has shown, however, it is vital that we attempt the impossible or there is the risk of worse consequences ahead. It’s better to plot a new course for the supertanker now than to stay put and sink into ever more murky waters.
