Two crises for the price of three

We are living through two crises, for the price of three, thanks to the authorities.

The first crisis was the massive overextension of borrowing in the Credit bubble, which low interest rates and loose banking regulation, off balance sheet financing and a culture of buy now pay later fuelled in the early years of this century. Government led this movement, making extensive use of off balance sheet financing itself.

The second crisis is the gathering slump, brought about by the authorities calling a belated time on the credit bubble with high interest rates and tougher banking regulation. They decided to change the attitude of buying things on credit in the private sector.

One of the reasons we are making such slow progress in sorting out the recession is the authorities are still unclear which of these two problems they are fighting, and which is the priority for their attention. Part of their actions are designed to stop another Credit bubble, actions which make it more difficult to turn round the slump.

It might be helpful to recap the main actions being taken by the UK authorities and to categorise them into one or other of the crises they are trying to tackle.

Interest rates.
These were lifted to higher levels and kept there to curb the Credit Crunch. Rather late in the day these have now been lowered to tackle the recession they have helped create. It will take time for the beneficial impact of lower rates to work through. In the meantime the very low interest rates now make it more difficult to banks to attract and keep deposits, at a time when the Regulator wishes the banks to become more dependent on deposits as a source of funds.

Capital Ratios
These have recently been raised and more strictly enforced by the Regulator. This is a policy to prevent another Credit bubble, which will make the downturn worse.

Banking liquidity
The proposals to increase the amount banks hold in cash and bonds is designed to fight the Credit bubble and to improve confidence in the banks. It will not help them extend more loans.

Money market activity
This has changed substantially from the very tight money to fight Credit expansion which brought the slump on, to much looser money, to begin to combat recession.

Loan guarantees
The recent proposals may assist in expanding bank lending and therefore increasing bank deposits, an essential prerequisite for recovery.

New share capital for banks
Given the likely rate of loss in the current nationalised banks this is unlikely to lead to more lending. The danger is it will allow banks to take longer to cut their costs and improve their business models, something they need to do quickly.

VAT reduction
This was designed to boost demand and therefore economic activity. It is failing to do so, as it did not put any new money into people’s pockets. Income tax reductions would have been better. Not all of it would have been spent, but people do need to repair their own balance sheets before they can spend more.

Increased public spending
This is also designed to boost demand. It will do to a modest extent. Some of the spending schemes are going to take a long time to get up and running, as they are large capital projects with long planning and legal processes to go through before any contract is let.

This is a very mixed picture, showing the confusion by the authorities over what they are trying to do. In the meantime the rapid deterioration in the real economy is making the task of turnround more difficult. There are a number of ways the downturn is gaining its own momentum.

The banks remain weak. They may well have to write more off their corporate loan books and their property loan books, as asset values continue to slide and as trading businesses experience more difficulties. As the banks are strapped for cash to lend, they are likely to force more companies into bankruptcy, which in turn leads to bigger loan losses for the banks, further undermining their ability to lend to others.

Many companies are experiencing unusually large reductions in demand. This forces them to sack more people, as there is nothing for all the employees to do and insufficient money coming in from customers to pay the wages. The more people who are laid off, the less people will spend. Those sacked have less money to spend, and those still in jobs want to repay debt or save as they feel insecure.

Companies find potential customers cannot raise the money to buy the goods, or find there is no trade insurance and credit to lubricate transactions. They have to become more suspicious of their suppliers, and require prompter payment from customers to minimise the risk of loss. The tightening of trade credit adds to the financing woes of business.

So how does the government break the damaging cycle? It needs to make sure all its policies towards the banks are designed to encourage more normal lending levels. It needs to maximise the favourable impact on jobs and activity that its spending creates, it needs to control its overall borrowing, allowing for the cyclical increase in the borrowing requirement, so that it can continue to finance itself sensibly.

I will write more about the bad bank/good bank idea tomorrow. I would advise the government to be very cautious about such an approach. The last thing we want is to saddle the taxpayer with all the bad debts of the banks, letting them go back to making big profits and paying big bonuses freed of many potential losses from past business mistakes. You cannot solve the problem of bad debts by transferring them from banks to taxpayers.

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25 Comments

  1. rugfish
    Posted January 16, 2009 at 8:01 am | Permalink

    Unless I’m mistaken…………..

    Tax cuts would have led to higher spending, more money to the treasury and more businesses transactions for banks. They would also have led to higher deposits and also to reducing liabilities of the bank as some people chose to save and repay debts as opposed to spending. In all circumstances, the bank and the treasury would have stood to “win” and the recession may not have been as harmful in terms of lost jobs.

    Good bank / Bad Bank – placing bad debt into a bad bank ?
    Firstly, not even the banks themselves know where the ‘bad debt’ is for they are comprised within entangled financial instruments with false risk ratio’s. Overseas debt being the worst, as banks invested in U.S. Sub-Prime which was sold at far higher risk than in the UK. There was hardly much risk in UK lending by comparison however whilst employment stayed at decent levels, and tax cuts would have helped that too.

    If a “bad bank” was created then it could feasibly take in only UK debt.
    This is surely a burdensome prospect to the UK taxpayer but the alternative is to see depression, lost jobs, less revenue and a longer climb out of it for banks to sufficiently regain something like normal loending conditions.

    Such a thing would also avoid many social issues along with the costs that go with them, but it doesn’t all HAVE to be down to the taxpayer as banks could basically swap the bad debts for capital and agree to “repay” that capital to the taxpayers in lieu of the debt rather like a mortgage. Remembering also that returns would be coming from those instruments to the treasury itself and together with the banks repayments, diminishing risk daily. Repayment by the banks ( buying back the instruments over time ), would depreciate the banks ability to pay “fat salaries and bonuses”, and 10 or even 20 years could be placed against this “Bankers mortgage”, in order that the taxpayer is returned to equilibrium in due course whilst bank assets could also be placed as collateral against those debts and any shortfall could be met with an ‘insurance policy which eliminated the risk of non-payment or default’ by the banks themselves, just like you would a mortgage.

    The amount of capital raised this way in tandem with higher deposits from savers and higher numbers of business transactions, would give the banks immediate liquidity, and give banks the ability to fund businesses themselves without the government having to step in with a “guarantee”.

    Homes, businesses and banks ‘could’ be saved whilst taxpayers liability would be safely protected and diminishing whilst the treasury continued earning from the process as a charge could be made upon the banks under the “bankers mortgage”, in addition to a diminishing risk and higher revenues.

    In this way, the taxpayer would be diminishing its overall risk, would have safeguarded banks from ruin and the country from recession, as the risk would be spread whilst providing means to actually tax revenue through higher levels of revenue than under a “recession”.

    Couple that with “cutting” some ludicrous spending plans and placing instead that money to oneside, then you have the possibility to avoid a recession altogether and thus avoid the extra borrowing set out by government along with the fall of investment which is being witnessed as the current plans are seen to lack anything other than more public borrowing and a recession which has no other means to end other than as a result of people sticking their hands in their pockets and borrowing large chunks of money to ‘spend’, but without either the means or the confidence to do so.

    • rugfish
      Posted January 17, 2009 at 8:33 am | Permalink

      Edit: 17/01/2009:

      http://rugfish.blogspot.com/2009/01/unless-im-mistaken.html#links

      Unfortunately, unless money is made available then a cycle of deeper depression will continue to spiral our economies downward. We HAVE to clear the problem for bankers in order to help stave off the effects to people having to face real poverty as their asset values will continue to diminish through lack of demand brought about by lack of funding. Food prices will rise as wholesalers, retailers and manufacturers struggle to make a profit and importers grapple with dearer prices brought on by a devalued currency.

      It emerges today that Gordon Brown is now considering the idea of a bad bank or ring fencing of toxic assets on balance sheets. Ring fencing sounds good but it doesn’t create capital whereas a “Bankers Mortgage” which swaps so called toxic assets for good money, will.

      He asks banks to “come clean” about the toxic assets. However the instruments ( securities ), were cobbled together by the same rocket scientists who “lost” the Mars Exploration vehicle in 1998 because they’d been working metric measurements whilst NASA Control had been using imperial. Hence, the Mars Explorer shot off into space never to be seen again at a cost of $125 million. Oh, if it were only that much Houston wouldn’t have a problem !

      Let’s face it. The full amount of securities is never going to be at risk unless a tidal wave swept every home and borrower off the planet. They will always have some return and hold some value. It is deciding what value they really hold, and yet time to do this would in itself take a million life times to calculate. They are an unknown ! YET. They can be given a moderate valuation based on what you would expect a mortgage lender to do. In this case the mortgagte lender would be us taxpayers. The Central Bank can underwrite the assets. Let us imagine then that the Central Bank will LOAN banks HALF the assets value of the instruments. ( UK instruments only ). The bank in return clears its ‘potentially toxic asset’ and is now under an obligation to redeem the value of the “Bankers Mortgage” over time. 10 or 20 years. The Central Bank receives the repayments from the borrowers within the instruments, thus diminishing its risk, and it receives payments from the bank to eventually redeem the half value of the assets which are collateral for the Central Bank. Once the Bankers Mortgage has been redeemed then what securities are left are simply returned to the bank but they would have diminished in risk by the amount redeemed by both the bank and the borrowers of the assets held within the securities. ( It could be zero ). In which case the bank will have repaid the cost of the toxic assets ( over time ). The bank will have taken an insurance on the other half thus ensuring that the Central Bank is covered in the event the bank fails to redeem the assets which would themselves be a diminishing risk for the Central Bank as they would be reducing the risk by payments from the bank and from the borrowers within the securities.

      The bank should be charged at an appropriate rate of interest which makes a profit for the taxpayer if all is well and which continues to diminish the taxpayers risk further. Thus a Bankers Mortgage would cost the bank over 10 or 20 years, but it would leave it in a position to lend. Taxpayers will then not end up like the family in the picture.

      http://img413.imageshack.us/my.php?image=depression1011869c04822uo5.jpg

  2. david
    Posted January 16, 2009 at 9:37 am | Permalink

    I was rather surprised and disappointed that you have not mentioned the excellent news, that the government has not given in to the likes of Zac Goldsmith and given the go ahead for the third runway at Heathrow.

    However as your wrote this:-

    This is not the same argument as the argument about how large and where London’s main international airport should be. You will not curb the growth of global aviation by restricting one airport – that will merely shift traffic elsewhere at the margin.

    on Aril the 3rd, you are as delighted as I am.

    • A. Sedgwick
      Posted January 16, 2009 at 1:05 pm | Permalink

      Apart from whatever happened to democracy and the lack of a Commons vote on the third runway, with the time scales involved oil and aviation will be in noticeable decline by the time it is scheduled to be finished. At current production levels known reserves will run out in 50 years and this assumes political stability in the major exporting countries. By 2050 air travel for the majority will be longish haul in big, fuel efficient planes, which will be timetabled for full occupancy not the convenience of passengers.

  3. alan jutson
    Posted January 16, 2009 at 10:00 am | Permalink

    The Government can hardly lambast the Banks for off sheet borrowing when as I understand it, it has used this method itself to hide the true National Debt.

    PFI schemes, Bank Bail outs, unfunded Government Pension Schemes, increase cost of Benefits etc.

    Just where is all of this future money, which is now being pledged coming from ????

    How can we (the taxpayer) just underwrite all of the losses and expenses which seem to be mounting day by day, and mortgage our and our childrens future ad infinitum.

    Has anybody actually completed a true balance sheet of the Countries assets and liabilities ?????

    If so how do we stand, or does no one really know.

    Not a bad idea if the Government of the day had to have a yearly audit.

    Then again the EU is supposed to have one, and the Accounts have not been signed off for the last 14 years, and they still continue in the same old unaccountable way.

    • Robert
      Posted January 16, 2009 at 4:26 pm | Permalink

      a busted flush

  4. Tony Makara
    Posted January 16, 2009 at 10:30 am | Permalink

    The government cannot buck this recession, so the panic measures like shock and awe interest rate cuts, massive borrowing and eye-catching spending programmes are not going to tackle the fundamental cause of the recession, namely, debt. The reality is that there has to be debt write-offs, repossessions, businesses going under until we reach some sort of equilibrium, until the bad debt is ironed out of the system and is no longer creating the demand-for-debt that is doing so much damage and is clogging up the lending process.

    The chancellor should ensure that the post recessionary economy, the post debt economy, will be one in which we start with both stable prices and a stable currency. The current strategy is going to lead to the complete opposite, inflation and too weak a currency. The Labour government must take its eye off the next election and set its focus on the long term future of the British economy.

  5. Waramess
    Posted January 16, 2009 at 11:46 am | Permalink

    I suppose that for every economic view there is the mirror image and this issue is no different.

    The credit crunch itself can be said to have been caused by too low interest rates resulting from the Bank of England’s remit to control inflation minus a key component (house prices). This and the resulting monetary expansion and velocity almost required the banks to do something with the enormous liquidity in the market.

    So now we should be looking at increasing interest rates.
    I know this got Lamont into trouble but his increases were far too frequent and aggressive.

    Mortgage defaults and house repossessions are going to happen in any event as unemployment grows but the slower it happens the slower the housing market will be to bottom out and then recover, and until that happens companies will continue to go bust, and first time buyers will continue to be largely excluded from the market.

    Higher interest rates will make it happen faster but will make the recovery quicker resulting in less insolvencies and a shorter period of high unemployment.

    Buying the bad assets from the banks is another matter. I don’t think it is in serious dispute by any prism of economics that this will get the banks lending again however, remember this is what Anna Schwartz described as Paulson’s dirty little secret when, on finding out how big the problem really was, he changed the objective of the TARP from buying toxic assets to recapitalising the banks.

    Recapitalising the banks will not get them moving again as is becoming increasingly clear, it might only help prevent them from going bust.

    The loan guarantees of both parties do not amount to much more than a row of beans against a market said to be £600 billion but is probably much more and the Vat reduction will have some limited effect in the long run; but we all know what has been said about that.

    If the purchase of all the banks toxic debt proves too big to accommodate then the banks should be allowed to downsize slowly.

    The problem with the economics preferred by politicians these days is that they always look for the quick easy option (normally Keynesian witchcraft).

    This is a bubble bursting and there is no easy option, only the choice between the short sharp option and the long slow very painful option.

  6. chris southern
    Posted January 16, 2009 at 12:00 pm | Permalink

    I understand the goverment had to inject money into the banking pyramid scheme to avoid it’s collpase.
    But if it had looked at the real problems they caused for buisness, such as ridiculous rates and an increase in over all taxes then they could have reduced these (especialy the business rates)

    These reductions would have stopped a good number of business from going under as they wouldn’t have needed the banks loans, giving the banks time to sort themselves out.

    I think you are far too polite about how this goverment has handled everything John.

  7. Max Horn
    Posted January 16, 2009 at 2:18 pm | Permalink

    The next government have to bite the bullet and get rid of this Enron style, off balance sheet accounting.It’s very,very dangerous and it is going to result in a financial collapse.How the present incumbents manage to sleep at night having deluded the public all day,I ‘ll never know.

  8. mikestallard
    Posted January 16, 2009 at 4:35 pm | Permalink

    Thank you very much for your lucid explanations of the way through the forest. I have been following this excellent blog for some time now and feel I understand it: I know where it is coming from and where it is going.
    I do not feel we are heading for Zimbabwe myself, although I may be wrong.
    I do feel we are heading for 1946 – 1956, when I was a child, though. Cold, hungry, walking everywhere, scraping the ice off the inside of windows, often ill, it was bearable if unpleasant.
    Remember the three day week when we huddled indoors in the dark? I was stealing food to feed my family from the school where I worked.
    Crisis? What crisis? I see the green shoots already!
    Please may I be a baronet?

  9. Nick
    Posted January 16, 2009 at 5:16 pm | Permalink

    Share Cur Price Purch Date Mark Price Gov Price Size Purch Profit Profit Since Purch Total
    LON:HBOS 70.1 12/01/2009 84.1 113.6 8,500 -2,207 -1,190 -3,397
    LON:RBS 34.7 28/11/2008 52.7 65.5 15,000 -2,931 -2,700 -5,631
    LON:LLOY 98.4 12/01/2009 140.7 173.3 4,500 -847 -1,903 -2,750
    TOTAL -5,985 -5,793 -11,779

    So Brown’s lost nearly 12 billion on 3 banks

    Nick

  10. Nick
    Posted January 16, 2009 at 5:35 pm | Permalink
  11. Donitz
    Posted January 16, 2009 at 6:46 pm | Permalink

    I became a Parish councillor the other night, I think I may be the first Parish councillor in the UK under 40 years of age.

    Part of the local debate is the loss of Post Offices in our rural community. As you can imagine every one in the Parish council is against this. The usual arguments of “where will Mrs Miggins draw her pension” etc etc.

    There was a ghastly hush when I suggested that our local sacrifise from closing the Post Offices would benefit the country as a whole. It is a fact that our rural Post Offices are heavily subsidised by the UK Tax Payer.

    It would be our bit towards cutting Government spending and the current crisis we all find ourselves in.

    This could be the end of my brief political career.

    • Adrian Peirson
      Posted January 17, 2009 at 5:04 pm | Permalink

      I’d rather subsidise the Post offices than the Banks. Me, I’d let the banks fail, they don’t deserve rescuing. Lending out thin air credit and forcing people to pay interest on it is fraud, now these International Moneylenders and their Westminster frontmen have enslaved my children.

    • mikestallard
      Posted January 17, 2009 at 5:56 pm | Permalink

      Mine was when I was a prospective Town Councillor. I asked why taxes had to go up every year. Same ghastly hush. And (thank God) I was not elected.
      But well said, anyway. (PS I myself am a pensioner living in a village).

  12. Madasafish
    Posted January 16, 2009 at 7:32 pm | Permalink

    The Swedish model (on which the UK bailout was based) forced the banks to declare all their losses up front so the size of the problem could be discovered.
    The Japanese did not do this an dlost 11 years.

    Seems like we are like the Japanese.

    No Government money without FULL declaration of losses (in secret to government only).

    I expect this bailout to fail and Bailouts 2, 3, 4 and 5 to fail UNTIL the lesson of how bad it is is realised.

    Frankly I suspect the losses will be a factor of 10 larger than those initially recognised which means the banking system is probably irredeemably insolvent as the Government will be incapable of bailing them ALL out.

    Are I a pessimist? Yes

    Is the system working? No.

    Ask again in 5 years time.

    Depression here we come.

  13. D K McGregor
    Posted January 16, 2009 at 8:02 pm | Permalink

    No advice , no analysis . I think you probably know what you are about and are closer to power than any correspondent here .
    Keep at it , John , your day will come.

  14. Adam Collyer
    Posted January 16, 2009 at 9:05 pm | Permalink

    Absolutely right (as usual) and don’t forget that each crisis feeds off the other. So as the authorities fail to get to grips with either, both get worse.

    Surely we need to prioritise the banking crisis, which could be relatively easily resolved with higher interest rates and lower government spending, and leave the recession to run its course. Not a nice idea, but if we go on as we are, we could face disaster.

  15. John Archer
    Posted January 17, 2009 at 4:31 am | Permalink

    (personal remarks re Mr ClArke removed)
    By the way, I think it’s at least “THREE crises for the price of four, five or whatever”. Don’t forget the looming energy crisis. And I’ve just seen “Our Plan for a Low Carbon Economy” (http://tinyurl.com/econuts) which would make it worse. The policy is outlined in this document: http://tinyurl.com/full-horror.

    Un#######believable!

    Mr Redwood, how does a man like you stay sane when your colleagues come up with that kind lunacy? I reckon you must be some kind of übermensch. 🙂

    Just to be double clear, I declare I’m an AGW heretic. Yes, I reject the holy doctrine. The standard of science here (Hansen, Mann etc) is appalling and would be laughable if it weren’t so serious. The IPCC is a loonygreen political setup.

    Arguments from authority and so-called scientific consensus, which doesn’t exist in any case on this issue despite what you might hear, carry no weight, never have done and never will. Nor should they. And it’s not about believing or not believing – it’s about the coherence of the theory and the empirical evidence and weighing those up against any competing theories. AGW fails miserably.

    Here’s an example of that failure. For a statistical critique of Michael E. Mann’s AGW Hockey Stick graph (as abused by Al Bore in his bonehead film “Inconvenient Truths”) see the paper “What is the Hockey Stick Debate About?” by Ross McKitrick and Steve McIntyre here: http://freefilehosting.net/download/44447. It’s in pdf format.

    Note: Normally this is available at Steve McIntyre’s website, Climate Audit (on the “Hockey Stick ‘Studies’ ” page, http://www.climateaudit.org/?page_id=354) but the link to it is currently down for some reason. Fortunately for you lucky readers my colleague, Dr Trish Fremdlieb, had saved a copy some time ago and has uploaded it to the file hosting service above. It’s an easy read and you don’t need to be a statistician, but it helps. Furthermore, there are plenty of other goodies at McIntyre’s site but many are technical.

    However, if you have the time do search and check out Hansen/Mann’s etc responses to McIntyre’s requests for data and code. It will give you a flavour of what this debate is really about and clues as to the scientific (and personal) integrity of the main AGW proponents.

    Unfortunately most people have to rely on others when it comes to matters of science. Fine, normally. But when the science becomes politicised, as it has in this case, then people can easily be fooled. (removed personal remarks re Mr Cameron)
    There’s a serious about-face coming up on this AGW nonsense. But I hope those responsible for promulgating it get it full straight in the neck. These people are a danger and should be kept away from any kind of responsibilty, their judgment being so badly impaired.
    To think I used to vote Conservative.

    Still, I’d vote for you, John Redwood, but for your party — oh, that and the fact that I’m not in your constituency. 🙂

    P.S. On C.P. Snow’s “Two Cultures”: His was a forlorn wish — ne’er the twain shall meet. A genetic impossibility in my view. In today’s world especially, Parliament is overloaded with those from the wrong cultural. But it will never attract enough from the right one. Things don’t look too good.

  16. TomTom
    Posted January 17, 2009 at 6:45 am | Permalink

    Why didn’t the Treasury repatriate PFI deals from the failing banks and lower the cost of capital on those projects instead of becoming bank shareholders. This is Corporatism being reintroduced into the European economy – Mussolini would be so proud of Brown

  17. Tapestry
    Posted January 17, 2009 at 1:03 pm | Permalink

    What is Brown’s borrowing requirement in 2009/10 likely to be now with his attempted bank rescue by nationalisation already coming unstuck?

    This year’s GBP 157 billion will become next year’s GBP 250 billion and more.

    The IMF will be needed plus the expropriation of all shareholders including most pension investors. Brown will have robbed the old generation of its savings, at the same time sending the next generation into economic oblivion. I don’t think any political leader has so conclusively destroyed such a good economy as Britain’s was in 1997, in such a short space of time, throughout time.

    Bankrupt Brown will indeed go down in history as the greatest wrecker of wealth in the history of the human race. It really is quite an achievement.

  18. rose
    Posted January 17, 2009 at 4:20 pm | Permalink

    One thing I would like the conservatives to consider is something on the lines of their erstwhile rent-a-room scheme in which they gave people the incentive to take in lodgers once more without being punished for it.

    Now there are a great many old people with some means who need a lot of help, and a great number of younger women on benefit who might be able to give it – if they were allowed to earn this extra pin money (for shopping and running other little errands etc., as well as help with little tasks at home) which might also help to keep old people in their own homes for longer. As it catches on this might come in time to include teenagers, and help to restore the communication between the generations and thus help to mend the broken society.

    • rose
      Posted January 19, 2009 at 3:23 pm | Permalink

      Of course I realize all the restrictive health and safety and young people etc legislation would have to be dealt with first.

  19. Sava Zxivanovich
    Posted January 19, 2009 at 9:50 pm | Permalink

    VAT is reduced to cut inflation. December inflation will probably be 0 or less allowing further BoE base rate cut etc.

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