Yesterday the Governor of the Bank of England gave a lecture broadcast on BBC Radio 4, and was then interviewed by Evan Davis. The full text of his lecture is here and you can also listen to part of the broadcast interview.
Mervyn King was the Governor of the Bank of England during the financial crisis and was responsible for the exceptional actions taken during that period to support the banking system. In partnership with the Government and the rest of the Monetary Policy Committee (MPC), he has effectively managed the UK economy from 2003.
In his lecture and ensuing interview, did Mervyn King admit any responsibility for the financial crisis? No. He makes the extraordinary claim that "this was a bust without a boom" and followed it up in the interview with Davis with the even more extraordinary claim that the economy's growth prior to 2008 was sustainable. His evidence for this is that inflation was low, and unemployment was low, therefore had interest rates been higher they would have had a deflationary effect. Now, it is correct to say that the MPC's primary responsibility is to keep inflation under control. I had a look at the UK CPI (Consumer Price Index) inflation profile from 1997-2008 (i.e. since the independence of the Bank of England) and this is what I found:
The Bank of England's inflation target for a long time has been 2%. And for the first half of the 2000s this chart shows that CPI inflation was in fact mostly between 1-2%, which is not a bad record. But from 2004 onwards - shortly after King took over as Governor - CPI inflation started to rise. Did the MPC raise interest rates to counter the inflationary trend? Let's have a look:
Odd. It seems to have raised interest rates in 2003, when inflation was below 2%, then left them either unchanged or even reduced them in 2004/5 when inflation was rising. It didn't start raising interest rates until 2007, by which time it was all over bar the shouting - and arguably the interest rate rises in 2007 made an already bad economic situation worse. Stunningly good economic management, I must say.
In my view CPI inflation would have risen a whole lot more had the UK not been flooded with cheap imports from emerging markets:
In effect, the UK's increasing trade deficit and high cost base relative to its trade partners is what kept its CPI inflation rate lowish during this period. To be fair, King wasn't in any way responsible for that. A monetary policy response to discourage imports would have involved cutting interest rates, which would unquestionably have been a bad idea - it would have increased inflationary pressures and given even more encouragement to banks to lend recklessly. There are definite limits to monetary policy, and this is one of them: monetary policy cannot compensate for declining exports. Responsibility for the UK's poor export performance lies with the Government, not the Bank of England, and I don't mean just the Blair /Brown Government: the UK's trade deficit started to rise under Margaret Thatcher, at least partly as a consequence of the destruction of the UK's manufacturing base.
But the MPC only considers CPI inflation. That doesn't include house prices. This is how house prices behaved during that time:
Looks like inflation to me - rather a lot of inflation. This led to people taking on higher and higher income multiples, providing smaller and smaller deposits and generally over-mortgaging themselves. Household debt in the UK is something like 100% of GDP, of which by far the largest portion is mortgages. Many people are so over-extended that a rise in mortgage rates may mean cutting expenditure on essentials such as food. How can King IGNORE this? How can he say that economic growth founded on such enormous private debt is sustainable? Oh yes - he wasn't responsible for tracking asset price rises, only for managing CPI inflation. So to him, the economy had low inflation even though it was experiencing the biggest house price boom in history. I think they call this doublethink.
So King's claim that inflation was low is iffy to say the least. Is he any more accurate on unemployment? Here's the UK's unemployment record from 1971-2008 (I've chosen this time period because of King's remarks about the 1970s and 80s):
So yes, from 2001-7 UK unemployment was indeed lower than at any time since 1976. But wait - wasn't that the year that the Chancellor was forced to go to the IMF for a loan because the country's finances were in such a bad state after the recession of 1973-5? Yes, inflation touched 27% in August 1975, but that wasn't caused by a boom - it was caused by a combination of currency devaluation, external shock (oil price rise after the Yom Kippur war) and high wage demands in unionised industries. Unemployment rose as a consequence of distressed economic policies such as the three-day week - and it has NEVER RECOVERED. The "low unemployment" of the mid-2000s was HIGHER than the unemployment level in the 1973-75 recession.
So to me, King's claims that the economy had low inflation, when there was a massive house price boom, and low unemployment, when the unemployment rate was higher than in the 1970s, look like an attempt to escape any responsibility for the way in which the economy was managed in the 2000s. Interest rates during that period were lower than at any time since the second world war - and yet there was a lending boom. By his own admission, King KNEW banks were borrowing and lending far too much. Why didn't he raise interest rates? He comments to Davis that most of the pressure at the time was for interest rates to be cut. But a genuinely independent Bank of England would surely do the right thing for the economy, whatever the political pressure to do otherwise? Was it just that they didn't see the need? Or could it be that the MPC was swayed by political considerations and media squalls?
But if the MPC was swayed by political pressures before the financial crisis, what confidence can we have that they are any more independent now? And if they simply didn't see the need for interest rate rises or other measures to choke off the lending boom, why should we believe that they would see such a need in the future? What confidence can we have that the Bank of England's new regulatory body for banks, the Financial Policy Committee (FPC), will operate with genuine independence either? King talks about the FPC "taking away the punchbowl" when things in the financial sector start to get out of control. But the MPC could have done that, and didn't. Why should we believe that either of these committees would be any more likely to do so in future?
In fact one of the biggest challenges that the new regulatory body faces is trying to identify excessive volume and risk in the financial sector early enough to do something about it. The Fed DID raise interest rates, in 2005, in an effort to prick the mortgage lending bubble, but by that time it was too late - lending was already out of control and all it did was cause precipitous collapse of the sub-prime housing market. And in the UK the BoE did nothing despite the mounting evidence of an out-of-control credit boom. Arguably the seeds of the lending boom were sown in the interest rate cuts that were made on both sides of the Atlantic to support the financial sector after the 9/11 disaster. It's very easy to be wise after the event, but I can forgive people for not seeing at the time that they were over-reacting to an appalling event. But I can definitely criticise the MPC for failing to take action when it became apparent that lending was spiralling out of control. King's arguments that they "didn't see it coming" and "didn't believe it would happen" are naive. There are enough people who DID see it coming. It's just that no-one wanted to listen to them. Everyone was busy enjoying the good times and didn't want to hear bad news from the Cassandras.
You see, the fact is that we LIKE a certain amount of volume and risk in lending. We don't like it to be difficult to obtain credit to buy our houses and our cars: we don't want to have to put down large deposits or provide evidence of good steady earnings to obtain a mortgage. The Government is currently encouraging mortgage lenders to lend 95% of property value, despite the fact that these "sub-prime" mortgages are vulnerable to property price falls. There is much whining from the SME sector about the lack of cheap bank finance for risky startups and expansion. Yes, we want banking to be safer - but not if it scuppers our plans and stops us having the things we want.
So we have strident calls for banks to be "broken up", for the State to provide financing for SMEs and help to first-time buyers, for banks to be forced to lend. None of these are coherent arguments - they amount to retaliatory attacks from people who are understandably angry about bailed-out banks refusing to help them.
King's "three R's" - "regulate, resolve and restructure" - look uncomfortably like American marketing to me and I suspect him of playing to the gallery. And the proposals that I have seen for at least two of these are inadequate.
- I've moaned about ring-fencing before, but here we go again. Ring-fencing only applies to three banks in the UK (HSBC, Barclays and RBS). It wouldn't have prevented the failure of ANY of the UK banks that went down in the crisis, nor would it have made any of them easier to resolve (except possibly RBS). And the American experience shows that although separation of retail banking does provide a measure of protection for ordinary customers, it also gives huge incentive to unregulated financial institutions to find ways of doing bank-like things such as taking deposits and lending. The so-called "shadow banking" network, which nearly collapsed in the crisis and was extensively bailed out by the Fed and the US government, grew to enormous proportions BECAUSE it was unregulated. The US is trying to bring this network into the light by regulating FUNCTIONS rather than institutions. It seems the UK wants to go in the opposite direction.
- Calls for banks to have more capital in relation to debt are sensible - so let's pay more attention to the leverage ratio, please! Calls for banks to have more capital in relation to risk weighted assets fail to address the problem that the risk calculations themselves are opaque and complex and regulators don't understand them. But if they are simplified - as they were under Basel I - they are an inadequate measure of risk.
- There are no proposals to amend the tax system to encourage equity financing over debt. It is not just banks that are short of capital. Many corporates are highly leveraged because of the preference for debt financing over equity. The fact is that debt financing benefits both the company (because interest on debt is a business expense so is paid from UNTAXED income) and the investor (because if it all goes pear-shaped creditors' claims are senior to those of equity investors). The standard measure of company performance, RoE (Return on Equity), also encourages companies to keep their equity base small. Until some action is taken at Government level to encourage equity investment, getting ANY company - not just banks - to increase their shareholders' capital will be like pulling teeth.
And here is the worst thing of all. King is clearly trying to reassure people that everything will be fine once the "brave new world" of the Bank of England controlling everything via its different committees is up and running. But nothing has changed really......
- We still have a fragmented regulatory system. It's just fragmented differently now. And it's still made up of the same people who failed so terribly in their regulatory responsibilities.
- We still have the economy managed by people who wouldn't recognise a bubble if it floated past the end of their nose, and who bend with every passing political wind
- We still have an economic orthodoxy that treats private debt as irrelevant and has not the faintest idea how bank lending actually works
- We still have a Monetary Policy Committee that has no mandate to manage asset price inflation
- We still have a Government that is trying to use monetary policy to compensate for fiscal incompetence and lack of coherent economic strategy
- We still have an economy that relies on debt to give people what they want and need. The individual debt burden continues to rise.
King warns at the end of his lecture that taking away the punchbowl wouldn't be popular. He's right - preventing people borrowing to buy houses and finance businesses won't win elections. No Government facing an election would ever allow the MPC to pursue such policies. The Bank of England is only as independent as the Government allows it to be. So the punchbowl is set to stay and there will be more wild parties, and more massive hangovers, in the future.