Can you solve a borrowing crisis by borrowing more?

The government has a strange idea that you solve a problem brought about by borrowing too much, by borrowing more. The Prime Minister yesterday went out of his way to stress he wanted the private sector to borrow more from the banks. He has made it well known that he wants to take the public debt to unheard of peaks.

The main reason his strategy will not work well is that it is fundamentally flawed, muddled over what the origins of the crisis were and even more muddled over what the solution might be.

The government and monetary authorities made two mistakes, not one. Their first mistake is well known and understood now, late in the day. They kept interest rates too low for too long, and set regulatory rules which allowed or encouraged banks to balloon their balance sheets, taking on too much risk by lending to people who would find it difficult to pay back, and playing financial games with each other through the derivatives and futures markets. When this had gone to extreme levels the authorities decided to call time on it.

They then made their second mistake, too little understood or acknowledged. They raised interest rates too high, and changed the capital and other regulatory requirements on banks too abruptly, causing the opposite problem. They brought on a sharp deceleration of credit, as they were forcing a sharp contraction in bank balance sheets. I see this as an even worse mistake than the credit expansion. Yes they needed to deflate the bubble. No they did not need to do it so sharply and to such an extreme extent.

Now they are in panic mode. They are worried about a self feeding slump/credit crunch. Banks unable to lend more have to withdraw money from companies that need it to stay afloat. Low asset valuations in asset markets starved of money means as companies go into liquidation banks will not get back all they lent to them as the assets are sold off. Banks then lose more money, and in turn have to lend even less as the losses erode their capital. Meanwhile the authorities slashing interest rates too far mean the banks again struggle to make any money on lending, so delaying the day when they will have more capital which they can use to lend more. The government is now trying to be the main borrower and lender, owning banks, borrowing colossal sums of money, seeking to reflate the general economy and to prop asset markets. It is trying to do too much with too much.

So what should it do? It should go back to ask itself why the authorities thought they had to deflate the bubble in the first place. They did so because the three UK deficits were getting out of control, and were beginning to create inflationary pressures.

The UK was simultaneously running a very large private sector deficit, as banks and companies borrowed too much, a large public deficit as the government borrowed too much, and a large balance of payments deficit as the public and private sectors imported goods and services which the UK economy was too stretched to provide, paid for with the borrowed money.

The government is tackling these three deficits in very different ways. The private sector deficit is being brought down by tough measures forcing individuals and companies to rein in their spending and to save more, because there is no longer the credit available. Many individuals face job loss or wage cuts. Many companies face falling turnover, plunging profits or a trip to the Receiver.

The balance of payments deficit is being tackled partly by the squeeze on demand, slashing demand for imports, and partly by a huge fall in the currency. A cheap pound will make it easier to sell our goods and services abroad, and will prevent us buying so much from overseas, as the prices of imported goods and foreign holidays rise by around one quarter.

Meanwhile the government debt is being doubled, as the government tries to limit the damage done to private sector incomes and prospects from the first two adjustments.

All this is very unhealthy. I am glad to hear the Conservatives say they want to do it differently. They see the need for the public sector to make a contribution to the country getting back to living within its means. If the public sector is cushioned from any of the downwards adjustment, it just means bigger job losses and a bigger income squeeze in the private sector. In order to share the pain, the public sector has to rein in its wilder and more wasteful spending, to concentrate on the basics of good health, education and defence. The public sector needs to control its borrowing, which means being much more careful about the money it tips into banks. It could agree a more gentle timetable to get the banks balance sheets into a more prudent position, avoiding the need for extra state capital. It can ensure they carry on trading by the Bank of England acting as lender of last resort against proper security.

What makes no sense is for the PM to say banks must lend more, at the same time as carrying on with his regulatory policy of making them run more prudent balance sheets. The two policies pull in opposite directions, and in this climate the regulatory imperative will win and the banks will stay cautious.

We do need to correct the balance of payments deficit, the overstretch of bank balance sheets and now the over borrowing of the state. We need to do so at a measured and sensible pace, not in this hectic extreme way.

The mood of the times is to save a bit more and borrow a bit less, to lend moderately to people and companies who can afford to repay it, and to consume less to live closer to your means. The government needs to understand this has to apply to it as well.

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21 Comments

  1. Posted January 5, 2009 at 9:09 am | Permalink

    Great blog, its a shame people dont learn from history!!

    Its not the first time this has happened, we will recover! Its just a fine line between helping a recovery and making the recession longer!

    I hope the Government listens to your comments John, now is not the time for Labour to play party politics!!!

  2. Posted January 5, 2009 at 9:41 am | Permalink

    Decision making on interest rates and regulatory rules should be made by the Chancellor in conjunction with the Governor of The Bank fo England. The FSA has no place in these two key areas which are preventing ONE economic policy working. There is no cohesion between decision making, no leader and a lack therefore of control over the problems which are all inter-relative to one another. In short ONE central decision maker needs to be in charge in order to steer all areas of the economy out of recession.

    The current crisis for firm control, lots of late nights, lots of brow beating and lots of decisions from an economic LEADER who will help to promote CONFIDENCE back into finance by encouraging political and financial calm to both the public and to the markets.

    The problem now, is no one knows WHO is in charge, no one is enamored with the governments plans ( i.e. we all lack confidence ), and no one will be reassured by Brown who one minute says the Bank of England controls interest rates then the next minute says HE does not expect interest rates to fall any further. He is kidding no one that the MRC are really in charge of interest rates, and even if they were then they should all be sacked. The truth is, you could drop interest rates to minus 1% right now and it would make no difference because no one has any confidence, therefore demand is low, therefore production is low and therefore people are being laid off or under fear of job loss and essentially lack confidence……An unhappy cycle as you indicate and one which has to be broken before the whole economy is dead.

    The ailing body must be revived by ONE surgeon and at the moment there are six pair of hands on the heart of the patient all getting in each others way.

    A General Election would inspire confidence.
    One voice on our economy would inspire confidence and focus all our minds on “The Plan” to put it right, giving us someone to blame when it went wrong or someone to praise when it went right.

    I nominate YOU as that man Mr Redwood, so please organise a General Election for us this weekend and I’m sure we’ll all get through this together. However I fear we’re in for a long year of decline, the likes of which we’ve never seen, which will take another 2 to 3 years to recover from if you don’t until “someone” gets a grip on it.

    • Posted January 5, 2009 at 9:45 am | Permalink

      That should read MPC of course, not MRC.

      Equally, your headline should read borrowing, not bnorrowing I guess. lol

  3. Posted January 5, 2009 at 10:13 am | Permalink

    In reply to the question, no.

    What most commentators seem to completely overlook is that ‘credit’, in the wider sense meaning confidence – either in the economy in general; in one’s own prospects or in the ability of one’s counterparty to repay a debt (whether that is people depositing money with banks; or banks lending to households or businesses) – is FAR MORE important than ‘money’, which is merely a way of measuring ‘credit’. (click my name above for relevant article).

    Trying to solve the problems caused by the credit bubble bursting (i.e. confidence evaporating) by printing money or whatever is like realising you’re late for the train and putting your watch back five minutes.

    PS, “bnorrowing”?

  4. Posted January 5, 2009 at 10:13 am | Permalink

    Actually, John, I think it does make sense for the warped Brown to demand banks increase lending at the same time as ensuring they can’t by increasing capital requirements. That way he can continue to blame the banks unfairly as he is gambling, probably correctly, that the GBP won’t understand the regulatory problem but will observe the credit shortage and will draw the wrong conclusion – i.e. it isn’t his fault.

    It’s immoral, unsavoury and damaging to the country but when you’re only interested in your own short term political survival it has appeal for someone of Brown’s low stature.

  5. Posted January 5, 2009 at 11:07 am | Permalink

    Yes I saw our leader yesterday. First of all his appearance. He was either being shot through muslin, or he had really thick make-up on. Andrew Marr has always seemed to me to be a soft interviewer, and he didn’t disappoint. “We have far less debt than Germany, France, USA, and Italy.” was a statement that went virtually unchallenged. Is this true? or is it a (parliamentary) terminological inexactitude. Brown is either living in a fool’s paradise, or is lying through his teeth.

    Reply: Of course its not true if you include all the off balance sheet items and the banks.

    • Posted January 5, 2009 at 11:38 am | Permalink

      In reply to John Redwood’s reply, ignoring off-balance sheet stuff, the UK’s borrowing is in fact less than the other countries mentioned. Our off-balance sheet stuff (primarily £1 trillion for accrued public sector pensions) would get our debt close to 100% of GDP, BUT, to be fair, I have no idea what the comparable off-balance sheet stuff for the other countries is – I would not be surprised if they aren’t just as bad.

      Reply: I am talking about PFI, Network Rail, and the banks

      • Posted January 5, 2009 at 3:46 pm | Permalink

        Brown’s comparative stats are meaningless. Just because we are borrowing less than someone esle does not make it right, or even vaguely a Good Idea. You migt as well say that Hitler was a good chap because he killed less people than Stalin.

      • Posted January 5, 2009 at 3:48 pm | Permalink

        Yes, there is that as wel, but the net exposure is tens rather than hundreds of billions.

  6. Posted January 5, 2009 at 12:26 pm | Permalink

    JR – “Reply: Of course its not true if you include all the off balance sheet items and the banks”.

    We used to call that “fiddling the books” when I was a lad.
    Nowadays they call it creative accountancy but it’s still the same thing.

  7. Posted January 5, 2009 at 12:51 pm | Permalink

    I blame Charles the First who first set up the Privvy Purse with the Bankers.
    what was the Agreement, something along the lines of, We will lend you as much money as you wish, so long as we can have the interest via taxes from the Proles.
    Which is Why Govt Borrows our Money, at interest, rather than simply Print / Issue it Free of charge into the economy.

    Would we be in this position if we had Issued free of charge EXACTLY the same amount of money as we have borrowed over the past decades.
    Our children wouldn’t have a £1Trillion loan to pay back for a start.

    And these same people say that we should be ashamed of our involvement in the slave trade.
    Psychological repression while we / our children are enslaved, that’s a neat trick.

  8. Posted January 5, 2009 at 2:19 pm | Permalink

    If Britain were a PLC surely we would put a complete halt to recruitment and redeploy staff from non-jobs, or from causes that are non-essential, to frontline functions wherever possible.

    In addition we must abandon the futility of assuming that everyone out of work can ‘retrain’ in IT or further education.We desperately need jobs that replace the old non-skilled factory, mine or routine office tasks as this is the level that so many find appropriate, particularly given Britain’s educational failings for 30 years.

    A modernised National – or County – Service embracing:

    1. Military training (followed by service whenever apt)
    2. Environmental/Green
    3. Welfare with emphasis on the elderly, infirm and handicapped

    seems to us to be the obvious solution to replace
    unemployment benefits and to sweep up unemployed school leavers. The administration could be run without adding to the government payroll by redeploying currently non-productive public servants within central and local government.

    ently unproduct

    • Posted January 5, 2009 at 5:56 pm | Permalink

      When I was a boy, (1950s), the world was full of “little men”.
      There were porters on stations. My school was full of “Boots” and “Hards” and “Sergeant Majors”. There were shops for retired policemen on every street. There were hairdressers where you could listen to the latest gossip about football. Then there were pubs where you go and buy drinks at prices which did not need a mortgage to afford the beer. There were little men to arrange electricity, plumbing and the like. Our windows were cleaned without effort and regularly. Priests (my Dad) went around visiting the sick and needy and doing what they could for them. Doctors knew and loved their patients. Also, if you needed anything special like, say, mutton or venison, there were little men who could fix that too.
      These people understood the needs of people and met them.
      Do you know what? If I were now young I wold reckon that now was the ideal time to make a lot of money.
      People still have needs which are not being met. Several things are seriously undervalued on the stock market too.
      Meanwhile, our troops are seriously understaffed and ill equipped. Our teachers are pretty well all off sick (:-). Nurses are pretty well unobtainable.
      There is buckets to do. We need to free ourselves up to meet these challenges, not prop up a failing government in a failing system.

  9. Posted January 5, 2009 at 3:47 pm | Permalink

    Mr Redwood, the sense you talk is irrefuteable, so why aren’t you wheeled out on meeja more often? Oh sorry…

  10. Posted January 5, 2009 at 4:50 pm | Permalink

    We need David Cameron in power now! Gordon Brown will not be happy until he has destroyed the UK and saddled it with a debt so huge it will take many decades to repay.

  11. Posted January 5, 2009 at 5:25 pm | Permalink

    I am reminded of a phenomenon in aviation known as a pilot induced oscillation. Perhaps a simpler analogy is the pedestrian bridge on the Thames that wobbled due to the reaction of people trying to maintain their balance on it.

    The solution to both is to stop what your doing and let the system stabilise itself. Aircraft that pilots have ejected from have been known to level out once the pilot stopped pumping the stick. This is a bit like a yachtsman caught in a squall – let fly the sheets and steer into the wind.

    But Brown is now trapped in his own rhetoric – he has accused the Tories of “doing nothing”, while he is all activity and bluster, so cannot “do nothing”, even when it be the right thing to do.

  12. Posted January 5, 2009 at 6:14 pm | Permalink

    Cuts in public spending is the solution! But not £4.1 billions, it has to be much bigger!

    As for the message for the World – if the UK increases military budget even under present dire economic circumstance, a lot of people will wonder why. And their economies are in a much better state.

  13. Posted January 5, 2009 at 7:35 pm | Permalink

    This is the best analysis of the credit crunch I’ve seen so far

  14. Posted January 5, 2009 at 8:33 pm | Permalink

    You and the American Economist, Irwin S, explain things so eloquently. I just don’t understand why our Interviewers and Press don’t grasp the situation better.

    I cannot remember such companies as Wedgewood and Royal Worcester going into administration back in the early 90’s. Very sad situation.

  15. Posted January 6, 2009 at 8:09 pm | Permalink

    Why Borrow at all, if we had Just Printed exactly the same amount and we had borrowed over the Past decades there would be no debt nor interest to pay back and our children would not be enslaved to the tune of £1Trillion.
    this was of course always the Intention all along with the Money system, to enslave Humanity to the Real
    Govt in the Western world, the Military Industrial complex, owned by the Bankers.

    For undeniable proof of this, just look at where we are now and see who is holding the real wealth of the world in their hands.

    And look who is going to make a killing as values fall so they can step in once again and consolidate further by buying everything up at rock bottom prices.

    All deliberately engineered,

    A hostile takeover of a country or indeed the Entire Globe does not have to involve troops.

    Though if course if some countries refuse to allow Private Banks to take over, they can of acourse be forced to through Military means by simply placing them on the axis of evil list.

    Iran, Syria, Venezuela, Nth Korea, Iraq, oh wait we just did that one.

  16. Posted January 7, 2009 at 1:07 pm | Permalink

    When are we going to have a General Election and let the people decide remember the voters will decide if labour is fit to remain in government or not what is LABOUR going to cut is labour going to cut jobs is labour going to cut dept repayments is labour going to cut cutting taxes why are they allowed to get the country in the mess its in and how long they gonna to cut our waiting times for a new GOVERNMENT LABOUR signing away all our powers whats so great about great britain now LABOUR IS CLEARLY NOT WORKING IT HAS NEVER WORKED IN ITS LIFE AND MOUNTING DEPT PROVES IT AND BUSINESS FAILURES UNDER LABOUR HAS INCREASED

  • 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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