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.