Sep 07 2007
The UK monetary authorities - benign or malign neglect?
I thought it worrying that on one of the worst days of market turbulence the Chancellor of the Exchequer should spend his time rubbishing proposals from the Economic Policy Review I had chaired and which he did not seem to have understood, instead of trying to work with other Financial Ministers and with monetary authorities to sort out the crisis.
We now see that this policy of indifference to what is happening in the markets is spreading to the Bank of England. They solemnly announced no change in their base rate of 5.75% - the only trouble is inter bank rates are not 5.75% or anything like it. They are now pushing 6.9%. It makes the UK monetary authorites look powerless and irrelevant.
The UK markets have in the last few weeks put through an increase of more than 1% (100 basis points) in interest rates. These new interbank rates will become the rates that decide how much people pay for their mortgages and how much companies pay for their borrowing, whatever the bank of England may like to happen, unless the Bank does intervene to bring market rates back into line with its own base rate. The ECB and the Fed have been more active, trying to keep some control over rates in their respective markets.
Those who thought this financial crisis would just wipe the smile off the faces of some well heeled bankers and hedge fund managers should think again. The so-called “repricing of risk” which Central Banks have called for means dearer loans for many individuals and companies. It means banks trying to recoup the losses they have made on the last lot of dodgy loans, by charging more for new ones. It means less borrowing and dearer borrowing. It means slower growth. It will have an impact on house prices in the UK, as it already has more dramatically in the USA.
the UK authorities should not funk the decision. Do they really want interest rates to be 1% higher than their current base rate? If they do not, then they should use all their powers to intervene in markets to get market rates down to their base rate. Like the other leading central banks, they also have to decide when the problem has shifted from one of controlling inflation, to being one of avoiding too sharp a slow down. They were behind events in trying to control inflation on the way up. Indeed the main central banks all encouraged the credit pyramid by keeping rates too low for too long. It looks as if the UK authorities want to be behind events on the way down as well.
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John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College...
John, I am very worried about the prospect of underlying inflation and fear that cuts in interest rates will unleash the inflationary pressures that have been building up in Gordon Brown’s debt-driven economy. Gordon Brown has not once allowed the economy to cool in ten years and I worry about the consequences of continual debt-fuelled growth. We cannot allow inflation to return. By my understanding of economics an economy has to expand and eventually contract to iron out inflationary pressures and the fact that the British economy has expanded for so long now is troubling me. I fear that the economy must be overheating?
reply: I do not think so. The important thing is to watch wage pressures. If the economy were overheating we would see upward movements in wage settlements. Instead, this year the government is at last getting public sector wage settlements down - they have been the most inflationary in recent years. We see strikes and threatened strikes as a result, but no evidence that HMG is going to back down. meanwhile, private sector wages remain under good control.
John, I think it’s time for some deep reform of commercial banks. International banking crises seem to happen about once every seven years (sunspot cycle?), and always seem to feature the same suspects - French commercial banks and German landesbanks.
Commercial banks are essentially 17th century commercial structures tooled up with 21st century technology and 19th century commercial law, and have access to pretty much any and every asset market in the world.
Yet time and again, they prove themselves unequal to the task. And, worst of all, every time they get themselves into trouble, you get the same response - someone (the central bank) must bail them out. It seems the only lesson learned from the Great Depression was that banks are too important to go bust. So we get the near-equivalent of a government guarantee, with predictably disastrous results for commercial behaviour.
Perhaps instead we should ask whether commercial banks still have a useful function to perform, and start to imagine how one could safely wind them down. Does a world in which information distribution costs are effectively zero still need to bear the costs and dangers of commercial banks who claim they have some special insight or expertise to agglomerate and allocate savings. What would Hayek say?
Here are two possible reforms. First, the next time a French commercial bank (German landesbank etc) gets itself into trouble, perhaps the response should be to liquidate it, and distribute the assets to the depositors in listed money market mutual paper (ie, so it can’t go bust).
Second, since it is clearly the case that in some of these organisations, some employees are paid very large sums indeed to throw around the banks’ balance sheet, we might consider whether they should also accept some capital liability as de factor owners of the business. For example, the bonuses could be legally seen as bank capital for a set period - so if irresponsible traders lose depositors’ money, they too are exposed; or perhaps the bonuses could be seen as a dividend from assumed capital, leaving them legally liable up to the full extent of the assumed capital. Sounds drastic, but common sense, and repeated experience tells us the current divorce between reward and personal risk within these institutions encourages recklessness and/or managerial incompetence.
Third, given that interbank market rates are now higher than straight money-market rates (yup, check it on BBG), perhaps one might consider establishing a London extra-bank market, in which commercial banks are specifically not allowed to trade. Might bring down risk premia!
Reply: Certainly the owners of banks that go wrong should lose money from the experience, and they would be wise to make sure their senior executives also took a financial hit from failure.