Some analysts and commentators think there are two different problems, the banking crisis and the threat of recession. Now large sums of public money have been offered throughout the western world to increase bank capital they imply that the first crisis is on the mend, and maybe sometime we can start thinking about the second problem.
Unfortunately these two problems are all part of the same crisis. The banking crisis began when people in the USA were unable to pay their mortgages, and in the UK when a mortgage bank was unable to meet the demands of its depositors. The banking situation deteriorated this summer as forecasters came to see that it was not just US sub prime mortgages that could destabilise banks.
It is now important to make sure that the measures taken to restart the inter bank and money markets do not make handling the recession more difficult. If the economies of the west fall too far and stay down for too long, the banks will lose a lot more money on bad loans. It will not just be the UK and US mortgage books that cause problems, but the outstanding loans to companies will also be a source of weakness.
It is also important to ensure that public finance does not become overextended. In the days of the credit boom the UK government helped stoke the fires by its own activities. It borrowed huge sums under the Public Finance scheme and through Public Private partnerships, as well as through traditional borrowing. It added the loans of Network Rail to the taxpayer’s account. It is now about to add further huge sums through its bank nationalisation scheme.
The problem with a sharp slowdown or recession is that it damages the financial position of most people in the country and it greatly increases the strains on public budgets. Tax revenues fall. In this downturn Stamp Duty has been hit severely as the housing market dries up. Taxes on company profits, especially those on financial sector companies, will be greatly reduced in due course. Income tax on high incomes and bonuses will fall as a result of the job losses and lower profits. Spending on unemployment benefits, housing support and other government measures to handle the human misery that comes from a downturn will rise.
Gordon Brown used to call such spending the “costs of economic failure” which he rightly wished to reduce. Containing its increase should now be the prime concern of the government. Public finances are in a weak shape going into the downturn. We need to limit its depth and duration to keep government borrowing in some check.
My critics still complain about my support for lower interest rates. Savers understandably do not want their interest rate reduced, and tell me that we need to encourage savings because we have saved too little. Encouraging more savings by higher interest rates would have been an excellent policy three years ago to reduce the extremes of the boom, but is not the right measure now. Today we need to limit the downturn. That requires more spending. The danger now is there will be too little spending, cutting the money people pay to companies for goods and services. That leads to a bigger downturn, a more expensive burden on the state and more people out of work. In the end it also damages savers, because in the end in a big downturn interest rates have to be slashed to very low levels to try to get activity going again and to save some businesses. Savers cannot earn a high return with no risks. If savers want too high a rate of interest there will be more bank and savings institutions struggling, as the borrowers will be unable to cope. There are limits to how many risks the government can underwrite and how many financial institutions it can take over.
This crisis began because the banks lent too much to the private sector as well as the government borrowing too much. Between them they created a debt mountain. The Central bank and Regulator allowed this to happen, and even encouraged it by keeping interest rates low and drawing up easy going rules on the capital banks need. The Crunch began when the central banks decided to tighten conditions, with higher interest rates and less money available for the banks. Now the authorities seem to want to cut private sector lending sharply, by requiring more banking capital for a given volume of loans. Some of the strain will be taken by cutting bank lending to the private sector. If this has to be more than matched by more borrowing by the public sector to keep the banking system going and to pay the costs of recession, it is difficult to see what we have gained.