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.
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.
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.
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.
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.
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.