What should the authorities do now?

It was another bruising day on European markets. German shares fell 9%, partly because the German government offered a guarantee for all bank deposits then appeared to water it down. UK shares fell 8% where the authorities said they were thinking about what further measures to take. US shares fell a mere 3.5%, a further fall on the top of last week’s despite the approval of the massive Paulson bail out plan for the banks. Why?

Confidence has gone in the inter bank market. The money markets, under the influence of the Central Banks, are not functioning properly. If banks cannot borrow from each other and from the money markets, they have to reduce their own lending activities. Central banks are now trying to make cash available to the banks to get things moving again, but the banks are so battered by their losses and by past attempts of the authorities to reduce liquidity that they hoard the cash, putting it into ultra safe investments, when they do get hold of some.

I have been warning for months that this is a serious banking crisis, and that the authorities need to do more – behind the scenes – to strengthen liquidity and capital adequacy, seeking private sector solutions wherever possible. Now they are doing so, the second crisis erupts. This could never be contained as just a financial crisis. Because the authorities have taken so long to get up to speed, and because they have dithered or done the wrong things, the impact of the financial crisis on the rest of the economy will be worse.

The two crises now merge. The recession that is beginning to hit shops and garages, restaurants and factories, will cut the money coming into businesses. They will need to borrow more to see themselves through the downturn, but the banks will be unable or unwilling to help. Just at the time when business needs longer lines of credit at cheaper prices to avoid large scale redundancies and closures, the banks will reduce the credit they supply and increase its price.

The pattern in the UK is now clear for all to see save the Monetary Policy of the Bank of England. Collapsing oil, food and other commodity prices will come together with squeezed margins and the price cuts required to move stock next year, so inflation in 2009 will fall rapidly from its highs this autumn. Small business will be squeezed very badly by banks who cannot lend more and by customers who cannot afford to spend more. Big businesses too will struggle to obtain the credit they need and will be cancelling expansion and other investment projects. The authorities should be fighting recession, not inflation – they lost the battle against inflation a couple of years ago but it will cease to be a problem within a few months.

What options do the authorities have? The first is to cut interest rates drastically. Australia showed the way yesterday, cutting 100 basis points off her rates, even though her economy is still enjoying the benefits of Chinese demand for her commodities. The Australian bank appreciates there will be troubled times ahead. I have been calling for a 250 to 300 basis point cut in the UK. There are now more voices backing that. Of course market rates will not snap back into line with base rates, but a big cut will help all those floating rate borrowers linked to MLR and will cut market rates to some extent. It’s bad news for savers, but we all have an interest in avoiding more bankruptcies throughout the business and personal sectors, including those of us safely paid by the state.

The second is to work behind the scenes, bank by bank, to ensure liquidity and solvency are up to good standards. There needs to be intelligent bank regulation and intelligent central banking, based on a better understanding of the realities of the banking and money markets.

The third is to put the public accounts into better shape. The government itself in the UK set a bad example with its PFI, PPP and other off balance sheet financing and with its big build up of debt. Transferring the liabilities of the banking sector to the taxpayer is not going to solve the problem. They will not necessarily be better managed by Ministers, and the state cannot afford to take on any more. Fiscal prudence must include caution about taking on difficult debts. The state is the lender of last resort and needs to be so. At the moment it is the main lender. It needs to wean the banks and markets off such a dependence. Buying out the banks would not remove that dependence, but make it much longer term , and ensure the losses rested with taxpayers. At least the Bank is being cautious – if reports are correct – in demanding plenty of security for the loans it makes the banks, to protect the taxpayers. That is the least bad way to handle it.

There is no single magic bullet. The authorities – and the wider political and media establishment – should think about the meaning of the Paulson plan. For a couple of weeks we were told that if the US Congress passed the plan we would be saved, and if they rejected it we would be in deep trouble. The plan passed. The full $700 billion with few strings attached to its spending got through. Markets fell further and banking markets remained frozen. Let us hope when some of the money is released it is spent effectively and its starts to help the banks it is designed to support. In the meantime, European authorities with less money to spend should say to themselves they need to spend less a lot more effectively to start to lift the gloom. Confidence is a precious flower, only appreciated when it is wilting. No-one can be sure what words, what deeds, what events it will take to rebuild confidence. Anyone in authority today is walking on eggshells. Their words could do good or harm. Their deeds could make things worse or better. I wish them well, for all our sakes.

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21 Comments

  1. Tony Makara
    Posted October 7, 2008 at 9:37 am | Permalink

    The problem here is as much cultural as economic. The total adherence to free and global markets has produced too many lenders, a slipshod lending regime, speculation rather than investment and in the UK in particular a property market that is all about buying to sell rather than buying to build a home. In the short term the market should take a hit and allow the recession to run its course, to flush us clean of the bad lenders. Government and the BOE must set the focus on maintaining price stability, which will be the cornerstone needed for creating the new economy.

    In the long term we need to look at ways of developing a greater internal market, to break the dependence on China, to unplug from the global system that has made us so vulnerable. This will take strategic planning and support from politicians, it cannot come about through a free-market ideology with people pulling in different directions, we need a national economy, national unity, the piecemeal purchase of Britain by foreign concerns must end, all energy providors must return to British ownership. The globalists and free-traders are now watching their cherished system unravel before their very eyes, they promised us utopia but brought us to the brink of bankruptcy. Now we must usher in a new era of responsibility, of sound lending and an internal market that can support itself.

  2. Acorn
    Posted October 7, 2008 at 10:12 am | Permalink

    Is it time for Basel III? Should the Bank for International Settlement (BIS), take on a much greater control of national central banks under a new global treaty?

    We can be fairly sure now that our Lords and Masters do not have an adequate mechanism for calculating systemic global risk. There are clearly two different but parallel banking systems. In one are the commercial/retail deposit taking banks. In the other are the investment banks who are basically not regulated and work more like Corals or Ladbrokes betting offices, but not as well capitalised.

    It would have been nice to keep the two separate with a clear set of "rules of engagement" between the two. The US has buggered that idea by converting Morgan Stanley and Goldman Sachs into deposit taking banks.

    Deep derivative products like credit default swaps have a role to play; but, they can expand at the speed of light into the worlds longest daisy chain attached to some little bond somewhere at the back of a bank vault. Fortunately, a lot of them eventually cancel each-other out.

    The day of the pure investment banks may be over. There will be a lot less banks when all this is over; money will be dearer for a while; growth will be slower.

    Meanwhile, I am thinking of making a bid for Iceland, and I don't mean the shop. (Is there any good skiing there?)

  3. Kit
    Posted October 7, 2008 at 10:14 am | Permalink

    Dropping BoE rate will only effect a small group of borrowers. Are these the right borrowers to target? Could the cut have an adverse effect on the banks capital inflows?
    Until the banks built up cash holdings to replace their worthless assets nothing the authorities will can do will help – except make things worst.

  4. Iain
    Posted October 7, 2008 at 10:15 am | Permalink

    "Confidence has gone in the inter bank market."

    As I suggested in Andrew Lilico blog in Conservativehome…

    'The problem isn't deposit insurance, the credit crunch is about Banks struggling to get funds from the inter-bank market, which has become banks not wanting to take other banks as counter parties on their books.
    The solution to the unwillingness of banks to take other banks as counter parties is the same as has been done in the futures markets, i.e the counter party to a trade in a futures exchange isn't the person you have struck a deal with but the clearing house that guarantees the trade.
    In the case of the inter-bank market, it seems to me that the Bank of England should make its self as the 'clearing house' for money market transactions, and so in acting as the counter party to money market deals it should restore confidence in the money market and get it to free up. If this action was replicated by all main central banks international capital flows would be restored.'

  5. Acorn
    Posted October 7, 2008 at 10:34 am | Permalink

    I forgot to attach this article, notice it was written in August 2006. John will like this as it says that governments actually bugger things up, not derivatives.
    http://www.lewrockwell.com/rozeff/rozeff92.html

  6. Peter Mills
    Posted October 7, 2008 at 10:38 am | Permalink

    I read your blog daily and have become reliant on its clarity and intelligence in trying to understand what is going on. Thank you. Please keep posting.

    • mikestallard
      Posted October 7, 2008 at 8:26 pm | Permalink

      My son rang up this evening from Thailand where he hears all the gossip and is frightened of losing his life savings which are with the Nationwide.
      Because of this excellent blog, I was not only able to reassure him a little, but also to explain exactly what the problem was, what the likely outcomes were and that he really was not on the danger list – yet.
      So allow me to join you in your post – I thoroughly agree with every word!

  7. Neil Craig
    Posted October 7, 2008 at 11:57 am | Permalink

    The opposite of what we are doing now would be to accept that we ought to have a smaller financial sector. That if house prices fell to something closer to the manufascturing cost people wouldn't beed 25 year mortgages. Then the desire would be to quarantine the financial collapse so as to minimise it effect on the rest of the economy rather than, as now, for the taxpayer, ie the entire economy, to share the pain.

    There is no technological reason for recession – the oil price rise which started it is over, with prices now under $90 (remember that the $ has almost halved in value sincce Bush was elected so this is about te equivalent of $50 in yesterfay'sprices) & "peak oil" which was going to destroy our ecoomya couple of monnths ago is no longer problem.

    If we put 1/4 as much into supporting nuclear power, X-Prizes, GM, cutting Corporation Tax, fixing our crumbling infrastructure & cutting regulations as we are into propping up banks we would be in an enormous boom now.

  8. david
    Posted October 7, 2008 at 12:03 pm | Permalink

    So John! I do hope you'll be strongly opposing David Cameron's call for, 'part nationalising' of the banks.

    Mr Cameron does seem rather fond of all this 'Socialism' stuff doesn't he: are you in the right party.?

  9. Lola
    Posted October 7, 2008 at 1:28 pm | Permalink

    All very true. Trouble is the management of the country is in hands as hopeless and useless as the management of the banks. But, whereas the incumbent management of the banks can and will be changed (and soon) as a necessary prerequisite for their recovery, we'll have to wait another two years to see off the incumbent incompetent management of the country before policies can be put in place for our recovery.

  10. Johnny Norfolk
    Posted October 7, 2008 at 4:39 pm | Permalink

    Thank you John for a clear update on what is going on. There has been no explanations on the BBC just comentary on what has happened.

    Its a pity that you are not reported more widely. ah but you are a Tory and only the left are allowed time on the BBC.

    I notice just like the ERM we will get no help from France or Germany as its every man for himself as before.

  11. Tears for Tear 1
    Posted October 7, 2008 at 5:33 pm | Permalink

    This appalling government

    -its just that Brown simply can't make up his mind and really believes he can "leak" his way out of it.

    Except that the leak this morning reduced the mkt cap of RBOS from £20bn to £14bn.
    Probertly reducing the proceeds of a Govt 1-for-1 rights issue, to too small an amount to provide enough capital to provide a bottom for the RBOS.

    I genuinely believe that Cameron's "all party consensus" should be abandoned in the face of this extreme government incompetence, we are very close to a proper Bank Run, one that takes civilisations down with it.

    Who is going to be our Leo Amery?
    Who will say this to him in the Commons?
    "You have sat too long here for any good you have been doing. Depart, I say, and let us have done with you. In the name of God, go!"

    Go on John!
    Do um!

  12. Eddie Allen
    Posted October 7, 2008 at 5:34 pm | Permalink

    FOR SALE – ECONOMIC FALLOUT SHELTERS ONLY £100 EACH

    Roll up roll up !

    Get your economic fallout shelters here !

    I'm taking orders now so if you'd like to send me £100 please I'll send you a drawing of how to build one of your very own.

    Choose any colour you fancy as long as you have the paint.

  13. Mark Wadsworth
    Posted October 7, 2008 at 5:49 pm | Permalink

    "the authorities need to do more – behind the scenes – to strengthen liquidity and capital adequacy, seeking private sector solutions wherever possible."

    Exactly!

    The private sector solution is called "debt for equity swaps".

    Like Neil Craig, I am horrified that Cameron & Osborne are going along with this whole idea that the government should be spending one penny of taxpayers' finest on propping up banks.

    That's that fixed for now. And if you want to avoid property price/credit bubbles in future, sensible regulation is half the battle and replacing Council Tax, Business Rates, Stamp Duty Land Tax and Inheritance Tax with Land Value Tax will prevent them once and for all.

    • StevenL
      Posted October 7, 2008 at 11:13 pm | Permalink

      It strikes me that not very many people want to avoid the property bubbles on the way up, from what I remember nearly every homeowner in the land loved it. The only ones that complained were the ones who were stuck with their twenty-something kids living at home. The priced-out twenty-somethings hated it and have little sympathy for the people that whinge about their house is losing value.

      As long as the British people have a culture of owning their own property the ups and downs will happen. If a government creates a fiscal policy to deter asset price inflation, and it proves unpopular, the other party will simply promise to abolish it upon election.

      Why don't we just accept that boom and bust is a reality, even if it wasn't property it could be another asset class. People borrowed to buy shares in the roaring twenties and during the dotcom boom. If we all went crazy for some other kind of asset I'm sure someone would find a way of creating the loans to pump the bubble up.

      If you ask me, the sooner property falls 30 – 40% from peak the sooner the big wall of money out there will dip their toe in the water of recovery.

  14. DBC Reed
    Posted October 7, 2008 at 9:26 pm | Permalink

    I was rather hoping that this Conservative web-site would be meting out to the bankers the robust criticism that was formerly directed at the miners in the days before blogs were invented.After all the bankers are just as much on strike, having been given copper-bottomed public securities to replace the trash paper they had bought from the USA.The expectation was that they would resume circulating credit but this expectation has been confounded.

    Mark Wadsworth's suggestion of debt for equity swaps looks perfectly feasible but there appears to be little appetite in the City for anything beyond temporary part-nationalisation.But why temporary and why part?The only inference to be drawn from the temporary nature of the arrangement is so that the banks can be tided over and when they start making money again can be bought back so that the private sector can step in when big trouble-free money is to be made.The part nationalisation notion just affords a free ride during the trip back to profitability with the shares gaining in value along the way.

    Properly conducted national ownership of the production of credit is not only a useful stop-gap but a juster system whereby the nation resumes control of the common stock of money in much the same way as the Single Tax on land returns the profits of land (or economic rent) to the community.(The great land reformer Silvio Gesell also taxed the circulation of his money at set intervals.) Interest rates in a fully nationalised scheme could act as such a tax(minus the payment to savers)which could replace other taxes on the workers (already less burdened under LVT).Also Gesell's money circulated at a ferocious speed as people passed the notes on before the tax became due so unfreezing the system.

    At the moment LVT might serve to unfreeze the system somewhat because the banks could be freed to lend money on houses without fear that they would be getting into another bubble, which might develop from the value of the land underneath expanding before catastrophically contracting. The much sought-after floor in the housing market slide should be not some ratio of house prices to earnings(by definition inflationary) but as near as possible the cost of the bricks , mortar,labour + a profit.

    Reply: This is not a Conservative website. This happen to be my website, and I am a Conservative. I did not make critical comments about the miners, and do not intend to attack the many people who worked for banks doing a good job. I have already criticised the Directors and regulators.

    • mikestallard
      Posted October 9, 2008 at 7:37 am | Permalink

      At the risk of being repetitious, let's get the record straight here. It was actually the Clinton Administration which cajoled and then sued the banks into giving mortgages to totally unsuitable people. They did this on compassionate grounds, natch. Then, once the banks were full of useless debts, they allowed them to go international and sell the debts on, now bundled up with bankers' guarantees firmly printed on the outside.
      And, by the way, nationalising things, especially if you take all the fun out of it (bonuses and high rewards and risk), is not going to work in the long term.
      Even Tony Blair knew that.

  15. Stephen
    Posted October 7, 2008 at 9:32 pm | Permalink

    All good points – for which many thanks.

    What do you think re interest rates. Should they be increased or decreased ?

    Grateful for your thoughts.

  16. michael, islington
    Posted October 7, 2008 at 10:27 pm | Permalink

    "… seeking a private sector solution [to recapitalise] where possible".

    That's been the flaw in your argument. No private capital entity, or for that matter, sovereign entity, has been interested in investing in a UK bank.

    There is no alternative, as I think even Osborne acknowledges.

    Still taxpayers wake up tomorrow owning the banks. Socialism triumphs. The road to serfdom beckons.

  17. Freeborn John
    Posted October 8, 2008 at 7:02 am | Permalink

    The main problem is with banks struggling to attract funds. Without these funds they cannot lend to corporate or individual borrowers. Therefore interest rates should be higher to attract deposits from nervous savers.

  18. APL
    Posted October 10, 2008 at 4:33 pm | Permalink

    http://www.metro.co.uk/news/article.html?Brown_in

    Mr. Redwood, according to the report in the Metro, Gordon Brown has invoked anti terrorism laws against the assets held by Iceland and Icelandic Nationals in the United Kingdom.

    Do you think this is appropriate use of leglislation in this case?

    I don't think so, but it does in my opinion illustrate how easy it is to abuse this type of sweeping leglislation once it is on the statute books, regardless of the assurances given during the passage through Parliament.

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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