The naked King

In this post I use a number of charts from various sources. I hope you will bear with the mishmash of formats and fonts: I did think about doing my own charts, for consistency, but hey, life's too short!

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:

Historical Data Chart

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:

Future interest rates: Published by the Bank of England on 15 February, this shows the market's expectation for the base rate

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):
Historical Data Chart

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.  


  1. Bernanke is much the same: he attributes "the Great Moderation" period of the 90's or so to the wisdom of the Fed, and the housing boom and bust to just pure bad luck. He makes the case that the EZ had the same monetary policy, yet Ireland and Spain had a real estate bubble and Germany didn't.

    So is monetary policy irrelevant in housing booms? Or are central bankers so arrogant they've lost the plot altogether?

    Either way, great post.

  2. Bernanke does no such thing, he correctly sights a massive Asian savings glut, the effect of freddie, fannie and the shadow lending boom and the illusion of stability from a decade boom.

  3. Hi Francis

    I thought I would catch up after missing your target-2 post.Sorry!

    I would like to take your readers back to 2002 when a proposal was made to change the UK's inflation target to the Hamonised Index of Consumer Prices. Which was implemented in 2003. This replaced the Retail Price Index.

    So we had an inflation index which excluded the housing sector and just as oddly council tax followed by a house price boom which we did not respond too! Can anybody spot a flaw here?

    We will never know how much difference the change and it is not perfect on two counts.

    1. We targeted RPI-X which excluded mortgage costs. But at least RPI overall included housing costs as a signal.

    2. RPI counts housing costs via depreciation and mortgage rates rather than prices but again at least it tries.

    I would argue that something is better than nothing and would quite possibly and even probably led us to a better outcome .

    It is in my view a matter for their consciences as to why both Mervyn King and the MPC have invariably been silent on this subject..

  4. Hi shaun,

    I haven't finished with TARGET2 yet - have had extensive discussions with Beate Reszat about it and will write another post shortly. It's ridiculously complicated!

    I agree with you about the change to CPI. Had they stuck with RPI the asset price boom would have affected headline inflation figures to some extent, which would have forced the MPC to do something about it. There's no doubt in my mind that interest rates were too low. I know raising them to the level required to choke off the boom would have been painfully deflationary, but surely it would have been better than what actually happened!

  5. You seem to be suggesting that (i) the remit of the Bank /MPC is inadequate and (ii) the "independence" is a bit of a charade. So has the time come to abandon Bank of England independence altogether ? At least we'd know that the blame for any economic policy errors lies with the elected government................

  6. Anonymous,

    To my mind there either has to be GENUINE central bank independence - not a politically-mandated "operational independence - or overt political control. Personally I think separation of monetary and fiscal policy is about as realistic as separation of retail and wholesale/investment banking, so I wouldn't bother with the "operational independence" figleaf.

    Alternatively, we could abolish the central bank - as Austrian school economists would like!

    1. Many people don't seem to be aware that central bank independence was a Maastricht Treaty requirement for all EC member states which wanted to join EMU. We know that Tony Blair came into office determined to bounce the UK into the euro, and central bank (Bank of England)independence was a necessary precursor. It has always irritated me the way it has been presented as a Gordon Brown policy.

      I have no idea whether the UK's treaty obligations would allow us to remove BoE independence - Frances will no doubt have a better idea.

  7. Central bank independence remains an EU treaty obligation. The IMF is also less than impressed with attempts to compromise central bank independence - as Hungary's recent experience shows. I'm simply pointing out that we don't actually have a genuinely independent central bank.

  8. If the BoE had really appreciated the risk of the housing boom, or had seen inflation a couple of percentage points higher than CPI, would have the resultant higher interest rate have any real effect?

    Given the boom was at the stage where 125% mortgages were being lent, would 2% more interest really have dissuaded the marginal buyer? I don't think it would have, nor would it have reduced the build up of consumer credit.

    Surely the proper policy tool would have been actual enforcement of robust countercyclical leverage ratios?

    1. BlackRaven

      Absolutely, I agree. Interest rates needed to be raised much earlier to be effective - as the Fed discovered. By the time the boom was evident, it was already too late. Which is why I commented about the difficulty of recognising a forming bubble and the even greater political difficulty of doing anything about it. By the time the bubble was big enough to be causing a problem, lending was out of control and direct intervention by the regulator would have been the only effective course of action. The FSA singularly failed to do this - and the BoE was indeed powerless in this respect. I question whether the new regulators will be any more effective than the old, since they seem to be the same people under a different name.

      However, I don't think King is accurate to claim there was nothing the BoE could do apart from "shouting from the rooftops". To my mind interest rates WERE too low throughout the 2000s, which fuelled the credit boom, and exclusion of housing costs from inflation measures meant that the MPC ignored it. Targeting CPI inflation alone is too narrow an interpretation of the "inflation control" remit, in my view. And there were other areas where the BoE clearly could have acted earlier: for example, at the time of Northern Rock's failure the BoE did not have a discount window facility, although they had apparently been discussing creating one. (The NY FED has had a discount window facility since the 1930s). The lack of a discount window facility meant that NR had to ask for emergency funding, which requires Treasury approval. Some idiot leaked this to the press, and the result was the first run on a UK bank for 140 years. The rest, as they say, is history.

      No one player is solely to blame for the crisis. The BoE was no more to blame than the Treasury, the FSA, the commercial banks, credit rating agencies, the Big 4 accountancy firms and a whole host of economists. The important thing is that we learn the real lessons from this crisis and put in place structures and procedures that provide the right balance between risk and safety. Banking is by definition a risky business. It isn't possible to make it completely safe, and it is very misleading to suggest that (say) the Vickers reforms will fully protect customers and taxpayers. They won't - and if they did, customers wouldn't like it.

    2. I would tend to agree with what Frances said above. As much as we may all like to say "aha - those are the wankers responsible for all this!", it really was a variety of reasons. Immoral bankers; BOE; the regulators who didn't regulate etc. It makes me think of the old phrase: Victory has a thousand fathers, while defeat is an orphan. Sir Mervyn is certainly proving that maxim right.

    3. Sure, rates were too low, the point I was trying to make though is that monetary policy wouldn't have really made that much difference imho. I agree that Vickers won't make any difference (especially the idea that you can separate retail and investment banking to reduce risk, given that intermediation will still be necessary to link savers and borrowers). I do think however that the appropriate tool is likely to be leverage ratios.

      As you allude to, the Fed's policy has always been to clean up the mess after bubbles rather than to try and prick them. Which may not be popular now, but in the long run I think is the correct strategy. It is sometimes easy to forget the good of booms and to think that perpetual sustainable trend growth is possible without cycles and volatility.

      Aaron Brown makes a really good point, and as a poor summary; in the US the gfc resulted in 5.9% job losses, even if you were very skilled and halved the risk in the financial system and only reduced growth by 30% you would only have broken even on the number of jobs lost and created over the cycle.

    4. I certainly think far more attention needs to be paid to leverage ratios. I mentioned this in the post. But realistically, banks will always be highly leveraged - it's necessary in order for them to perform their credit intermediation function. Deposits are debt, not capital.

  9. Your last paragraph is the nub of the matter. It wouldn't have mattered one jot if Mervyn King had been 100% convinced of the dangers ahead in 2003 onwards (say) and had mounted a campaign to try and slow the housing market down. He would have been sawn off at the knees by the occupants of Nos 10 & 11 Downing St (or by their media hatchet men) within a few months of going public (or even probably before that once the idea of what he was planning to do got round Whitehall). Do you no remember what the political atmosphere was like then? The Tories were unelectable, New Labour ruled the roost like some 'We are the Masters now' revolutionary cadre. Anyone who had so much as tried to get in their way would have been toast. To pretend otherwise is hindsight of the highest order.

    The greatest responsibility for the financial crisis lies at the feet of the Labour party, and Gordon Brown in particular. He ran the UK economy as his private fiefdom from 1997 to 2007, and didn't let go much when made PM. Whatever decisions that were taken in that period were either under his direct control, or if not countermanded, made with his tacit approval.

    He is the guilty man, and is up there with Ted Heath as men who through either their own incompetence or active direction have overseen the destruction of their own nation.

  10. Frances

    I have one question and two points but don't want to join the blame game. It is history and we have to deal with it but we need to learn from it too.

    1) Would the activities of the banks been any different had the base rate been higher? Even if the BoE had set interest 2% higher, the crash would still hve occurred sooner or later but then the economy would not have 'grown' either. I don't disagree with you over the complicity of governments or the BoE but in the last analysis it was the excess risk taken by the banks, particularly RBS buying into the US sub-prime market then trying to swallow ABN-Amro, that required the massive injection of taxpayers money. There was an interesting piece in the Independent yesterday that you may have seen.

    2) The issue to me has always been to do with the ratings agencies and their evaluation of a financial 'product'. A purchaser should be able to see exactly what they are buying. It is fundamentally corrupt that an institution will pay one of the 3 (US) agencies to rate a product. The way ratings agencies work seems to be illogical. So RBS (Greenwich Capital) and others bought complete rubbish. At the basis must be a proper evaluation of risk which is a very complex process. It may be that the UK or EU has to set up its own mandatory agencies with non-disclosure authority to drill down into a product. I was horrified to realise that the agencies and banks had been using a copula model to simplify the evaluation of risk. This was a valid mathematical approach - as long as there was substantial contemporary non-copula evaluation in the market. But over 5 years during an explosion of CDOs etc, the market became dominated by copula calculations which means that the original calibration were completely wrong.

    3) My second point is that much of the UK originated problem is in the housing market. This we also have Margaret Thatcher to thank for (oops - I said I wasn't going to blame anyone!). The collapse in house building since the early '80s, particularly in social housing for ideological reasons, was never replaced by the private sector so the supply froze almost completely. The sufferers have been those wanting to get on the 'ladder'. The BoE can't be held responsible for the demographic changes and general population growth so there is very little that can be done about the demand side. But successive governments have not tackled the supply side. To his credit, Prescott realised this and there was some move to increase housing stock with the release of brown-field sites but it was too little and too late. This is the simple origin of house price inflation. Credit controls or other artificial approaches may have limited the prices but at the expense of stagnating the economy. The government needs a much more pro-active housing policy to increase the supply of affordable housing. This will stop the excessive inflation in house prices. It is of course electoral suicide to suggest that house prices should be cut (although the market has cut them by about 15%) but in the long term we need to stablise house prices by increasing the supply, which will take years.

  11. Hi John,

    1) Crikey, that post from Ben Chu is so wrong I will have to write another blog to fisk it. He's bought into Broadbent's totally illogical arguments. I would have expected Broadbent to understand that debt may be unaffordable even if the value of the collateral held against it is maintained, and that households will cut DISCRETIONARY spending to maintain mortgage payments, which in my view is a large part of the reason for the UK's low demand. So I don't agree with Broadbent's main argument and therefore I don't agree with Chu either. Domestic private debt IS holding back growth.

    Nor do I buy the argument that Britain's banks collapsed because of cross-border interbank lending. The facts do not support this. Northern Rock failed initially because it was funding its mortgage book in the overnight repo market - you couldn't really get a worse liquidity mismatch than that. When the overnight market froze after Bear Sterns' collapse, NR couldn't fund itself. Ultimately its problem was very high leverage and hardly any capital, which is why it had to be nationalised. The problem at HBOS was very similar with the addition of some very dodgy corporate lending. Bradford & Bingley collapsed when the bottom fell out of the buy-to-let market. RBS was highly leveraged and very exposed in just about every area of its business; you really couldn't say that its CDO investments and ABN AMRO were the sole reason for its collapse. It was a mess, frankly.

    2) My general view on mathematical models is that the problem usually lies in the way they are used. In fact the copula model used to price CDOs quickly gave low or even negative prices at higher correlation levels. So the problem was the assumptions made by the users regarding correlation levels.

    I can't see any reason why public agencies should be any better than private when it comes to assessing risk. The problem of captivity exists either way - as we have seen all too clearly with bank regulators.

    You ignore the massive mortgage fraud at the heart of the sub-prime crisis. This is set fair to be the largest fraud in corporate history.

    3) I don't accept that the shortage of social housing alone created the housing bubble, nor that the sole solution is lots more house building. There are other social and demographic issues as well, and (of course) the cross-border mortgage lending that Ben Chu refers to - where do you think the properties are that these foreign mortgages were used to purchase?

  12. Frances

    Fascinating comments on the Ben Chu article. You are so right that discretionary spending has been cut by the consumer to pay the mortgage - the tragedy of the early '90s is still in the collective memory. So if and when interest rates start increasing, consumers will remain squeezed and still not spend.

    I didn't want to go into sub-prime mortgage fraud but of course this was central to the whole sub-prime issue, coupled with uncontrolled building.

    On mathematical models, as someone who has used these a lot albeit not in the financial world, and always had to write caveats which managers didn't always understand (but to their credit did ask), it is the assumptions that are made that are crucial. If CDOs etc were priced as negative, why on earth did the purchasing bank not realise this? Or was there fraud in the ratings agencies as well?

    I wasn't suggesting that a risk agency should be public (although I am not hostile to the idea) but just that it should in some way be paid for by the purchaser and have the right - no, obligation - to drill down into the product to see what is actually being offered. Goodwin's 'diligence lite' on ABN-Amro was the straw that broke that camel's back. But if it hadn't been RBS it would have been another bank I guess - Barclays were also racing to purchase (maybe they smelt a rat in time).

    On the housing front, it is not only social housing that has been an issue but all housing, particularly at the lower to mid range which is numerically the bulk of the market.

    The demand for housing is a function of both social and work pressures - people want houses, need to find work, may need to move for work, get divorced, have kids and so on. And the market responds.

    While there are imperfections as always, an inadequate supply means that prices go up. The few very rich people with foreign mortgages buying into Chelsea etc really don't bother me nor do the future tenants at The Shard who probably don't need mortages anyway.

    It seems to be that housing needs attention every bit as much as the health service and schools although it is difficult to get the genie back in the bottle of course. So it will take time and a long period of low house price inflation, which is never in the interests of any elected government keen to generate a feelgood for the ballot box...!

    At the moment people will sit on their properties - or have no option if they are in negative equity - unless they have to move. If and when prices start moving up again I suspect there is a lot of latent demand. We have become unhealthily addicted to housing so now all the rage is to build property portfolios because that seems the best place to store wealth.

  13. Frances

    1) You are very right that households will cut discretionary spending to keep a roof over their heads! And if people don't understand the difference between affording the payments and the value of the underlying property (or whatever), that's a bit sad. It is quite possible to go bankrupt in a mansion even with loads of equity.

    2) I have spent many years using mathematical models and many managers and colleagues were honest enough to admit that they didn't always understand them, particularly statistical models.I hope they learned something anyway!

    But I get the strong impression that such a professional attitude has been missing in some parts of financial modelling - maybe it was a get-rich-quick mentality but that could be unfair as I have never worked in such an environment. It may be that the modellers went to pains to point out the restrictions and which you sometimes need to make or matrices collapse and other nasties come out of the optimisation woodwork. Such models, properly designed and calibrated are extremely useful as long as the users and their superiors understand the assumptions that have been made.

    I wasn't ignoring the sub-prime mortgage fraud particularly and you are right that it could be collectively the largest in history but didn't want to go too far down that road in a comment (I kept hitting the 4kB limit)!

    But if some CDOs came in as negative or very low prices, what on earth were the banks doing? Or was it the ratings agencies? Or was it pure fraud again? It is all very fishy and none of the stable-door slamming by Vickers and co will get to the truth.

    3) I wasn't suggesting that housing new build should be only social housing but that is where I think the problem began in the '80s. We need a long term housing plan particularly for the south east where most people want to live along with infrastructural improvements.

    Such housing needs to be across the market and is IMHO the only way to prick the continuing housing bubble. Even if it is not entirely successful, it can only benefit the contruction industry that has been spoiled by massive PFI schemes and is now feeling the cold. Prices would have to be sensible or we would be left like Ireland with estates of unsold properties.

    It may therefore need tax or other incentives - that's the function of government but the BoE trying to control demand by interest rates is a very blunt instrument that will damage other parts of the economy, especially SMEs.

    1. Frances

      I agree with most of what you say. But, as your chart shows, there was a boom but not a bubble in UK house prices during the ten years before the financial crisis. That is, prices went up because of high demand for a limited resource, and because interest rates were low enough to make it possible to borrow the money, not (primarily) because of speculation. And hence they didn't collapse when the boom ended.

      In this respect, the UK is different from more sparsely populated countries such as the USA and Spain.

    2. Yes, fair point. Though that rather supports my argument that interest rates were too low.

      Interesting question though: US, Ireland and Spain all had housing CONSTRUCTION bubbles that burst. Why didn't the UK?

    3. Hi John,

      1) Totally agree with you about quants losing the plot. I'm not a quant myself and I admire anyone who can do math at that level. But there's no doubt in my mind that the math was misused - under pressure from senior management no doubt. Mispricing of CDOs etc. inevitably followed.

      The effect of the mortgage fraud was information asymmetry. Securitizers did not know the actual risk of the underlying assets, and because they were using Li's Gaussian copula formula for pricing (which uses CDS prices as a proxy for default risk) they did not "need" to know so did not ask for documentation. Had they done so the documentation fraud might have been nipped in the bud and CDO pricing might have been rather different. As you say, there needed to be proper non-copula evaluation of risk.

      2) I'm not denying the shortage of social housing arising from the RTB policies of the eighties and nineties. I can remember my father, who was Housing Chairman on Bromley Council at the time and an avid supporter of RTB, railing against the idiocy of Government not allowing councils to reinvest RTB returns in new housing stock. The result is a serious shortage of affordable housing.

      But there are other issues too. People living longer means that there is a shortage of family housing because the elderly like to stay in their "own homes" rather than downsize; family breakup creates two homes from one; the 2000s saw the largest influx of immigrants to the UK in recorded history. And despite PaulB's comment above, there unquestionably WAS an increase in purchases of second homes and property as an investment, egged on by the media (BBC programmes such as Homes Under The Hammer encouraged people to see property as an investment rather than as a home to live in). There was also a boom (which is still continuing)in high-value property investment from overseas. The vast increase in student numbers has led to high demand for student housing in university towns. And here was, and is, a massive imbalance between UK regions, with people moving to London and the South East because that's where the jobs are. All of this added to pressure on an already limited housing stock. I don't think there is a simple solution to this: yes, we need more housing, but we must also address the demographic changes and the regional imbalances that lead to pressure particularly on the housing stock in the South East. Simply building more houses in the South East doesn't deal with the underlying issues.

  14. Frances

    1) The price-proxy in Gaussian copulas is the big problem because as GCs took over, the resulting prices that were used for the next iteration had been set by GCs and so on. It is a classic feedback error that should have been realised. I don't think Xi's original maths (you aren't American are you?) was wrong but as always the assumptions should have been tested more thoroughly. In modelling, the calibration data distributions and correlations should be reproducible by the model and I don't think this was regularly done or people would have spotted that the distributions were getting narrower and the correlations higher with time (ie there was no natural randomness in the subsequent iterations of calibration data).

    Surely you are not suggesting social engineering to encourage people to move north??? :-) I guess the BBC is trying this at the moment (Media City is very impressive). We welcome this of course - it has done wonders for our house price because we live in a very nice part of Manchester which will shortly have a direct tram link.... But that's the problem isn't it - house prices.

    In the end, people and jobs will cluster together just because there is a critical mass. And the bigger the properly serviced critical mass, the better. We do have other centres like Manchester, Birmingham, Bristol, Glasgow/Edinburgh etc and a number of government functions have been moved there. If industries and jobs can be 'created' there, fine. But the history of such approaches is not good - remember the Hillman Imp and Ravenscroft in Scotland? In the end the market closed one (because the cars were rubbish) so the steel plant closed too.

    It's like the rather silly idea of building an airport in the Thames estuary. London certainly needs more airport capacity but apart from it being a major breeding ground for birds which are particularly unhealthy for jet engines, it would mean uprooting all the businesses around Heathrow - which would probably migrate to Frankfurt instead.
    I could never understand the opposition to the third runway at LHR - it is needed on safety grounds and the error was not to say that. HS2 is a nice but very expensive idea.

    We are where we are, we have in London one of the dynamic cities of the world which is a great plus. Government can huff and puff but that's what the market says so HMG should roll up its sleeves and organise building the infrastructure to support population growth and, as you say, immigration, elderly staying in their homes, student accommodation etc etc.

    Some of these issues are soluble by higher density housing (students and dinkies particularly) on brown field sites but there are water, transport and utility concerns of course.

    The present government of course will not do this because of opposition from voters/supporters. So it is likely that the SE will become a less pleasant place to live (sorry about that!) and eventually businesses will relocate but maybe outside the UK.

    Sad but true but before all this, the financial system needs fixing.....

  15. Frances, I think you’ve missed the elephant in the room. I’ll explain.

    Your criticism of King is not too strong. Granted inflation was around 2.5% in 2006 compared to about 1.5% for the previous five years or so. But 2.5% is a long way from hyperinflation. I.e. King was more or less right to say that inflation was under control.

    The elephant in the room is the HUGE drop in interest rates in 2008/9. Reason is that the crunch was caused by excessive and irresponsible borrowing. And the cure: cut interest rates so as encourage more borrowing! It’s total madness.

    I.e. if excessive borrowing is the problem, the solution is to RAISE interest rates. As to boosting demand, that could have been done simply by printing money and spending it into the economy, as I point out on my own blog.

    I agree that separating monetary and fiscal policy is nonsense. Modern Monetary Theory agrees with that. But I don’t agree with letting politicians decide what boost to aggregate demand is required: that amounts to letting politicians run the printing press and we all know where that leads.

    A committee of economists should decide what increase or decrease in demand is required, while politicians should decide the strictly political stuff: e.g. what proportion of GDP is allocated to public spending, and how that spending is split between education, health, etc etc.

    1. Ralph,

      I don't agree with you that inflation was under control. As Shaun points out, the measure of inflation was changed in 2003 to exclude housing costs....and as I said in the post, there was significant inflation in the housing market, fuelled by a credit bubble, which was excluded from headline inflation figures. In my view excluding something as important in people's lives as housing costs is much to narrow a view of inflation. Therefore in my view interest rates were too low throughout the 2000s.

      Interest rates should have been raised LONG before the crunch. In the credit crunch itself lending virtually stopped - and after Lehman, interbank lending DID stop. In fact the MPC did raise rates in the first half of 2007 and this arguably contributed to the lending collapse. Continuing to raise rates after September 2008 when lending had already stopped would have been the most extraordinary example in history of shutting the stable door after the horse had bolted.

      I am unconvinced that cutting rates (including QE, which is another form of interest rate cut) had much effect on lending behaviour after the crunch. The fact is that we have interest rates on the floor and still very little lending to the real economy. What the interest rate cut DID do was devalue sterling, which should have helped UK exports.

      I'm not happy with unelected "technocrats" deciding how much money people are allowed to have (which is what a "committee of economists" deciding the monetary base would amount to). And unless you are planning to end credit creation by commercial banks (including the credit creation that goes on in the shadow banking network), the monetary base bears little relation to the total amount of money in the system anyway - this is the fatal flaw in monetarist solutions to demand problems.

    2. The unelected technocrats would not decide (strictly speaking) how much money people had: they’d decide whether demand should be raised or lowered – though obviously “the amount of money people have” influences demand.

      If there is something wrong with unelected technocrats making this decision, why are most people happy with unelected technocrats in central banks deciding on interest rates? The latter power allegedly puts much of the above “demand” decision into the hands of technocrats. I’m simply saying: “take that to its logical conclusion and make technocrats 100% responsible for the demand decision.”

      I fully agree that interest rate cuts and QE didn’t have much effect. I didn’t mean to suggest otherwise.

      In your final sentence, you argue that the monetary base is a small proportion of the money supply, ergo changing it won’t have much effect. There are several counter-arguments, thus.

      1. When government / central bank prints money and spends it, it’s not just the change in volume of monetary base that has the desired effect: it’s also the fact of spending (and/or cutting taxes).

      2. I agree that POTENTIALLY changes in private bank created credit (irrational exuberance, etc) can have a big effect. Problem is that governments have very little control over this. In fact we are agreed that interest rate changes and QE don’t have much effect.

      3. There is no limit in principle to the amount of money that governments / central banks can print and spend: government could for example in extremis just stop collecting VAT and NI contributions and double the state pension, unemployment benefits, etc etc.

      Finally, I am interested in your claim that the shadow banking industry creates credit. I’m not an expert on this, but isn’t the shadow bank industry’s main activity to connect large lenders with large borrowers? To the extent that that is all they do, they aren’t “creating credit” in the same way as private banks create money out of thin air. If you know a lot about this, how about a post on the subject?

  16. Ralph,

    I'm distinctly unimpressed with unelected "technocrats" setting interest rates either. Especially when they ignore inflationary pressures in certain sectors and therefore set interest rates too low.

    Under our present system the size of the monetary base has little effect on spending in the real economy if banks aren't lending. This is because central bank money is intermediated through commercial banks. Conversely, if banks ARE lending broad money grows and the monetary base grows in response due to reserve demand. Monetarism has this the wrong way round, which is why monetarist policies such as QE have little effect on the real economy.

    I agree that were the central bank to spend DIRECTLY into the economy, then the monetary base itself could be used to control demand.

    Regarding the effect of bank credit, it isn't a POTENTIAL effect - it's a real one. I don't agree with the classical economic view that credit expansion can be ignored because it is balanced by asset creation. Excessive private credit expansion causes economic instability, as we have seen, but because the offsetting assets are people's savings and investments it is impossible to shrink private bank credit to more reasonable proportions without hurting savers - as we are currently discovering. However you look at it, private sector deleveraging is painful.

    I am planning a post on shadow banking, as even those who have heard of this mostly don't understand it. Shadow banks do credit intermediation and maturity transformation just as commercial banks do. Therefore they create credit just as commercial banks do.

    It's misleading to suggest that private banks create money "out of thin air". The only banks that ACTUALLY create money are central banks. Lending does create deposits, but the drawdown of those deposits has to be funded - and when commercial banks are creating large amounts of deposits from excessive lending, history shows us that they become VERY dependent on the shadow banking network to provide them with funds. As a last resort central banks will create new reserves to meet drawdown needs of private banks, which is how the monetary base expands as a consequence of private bank lending, of course. The circularity between savings (deposits) and lending is complex and involves both commercial and shadow banking.

    1. Frances, There is a recently published article which makes a few points about shadow banks here:

  17. I found your site while researching the commercial paper markets. I like it. Since you appreciate charts maybe you would enjoy my blog. Check it out if you get a chance.


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