Sunday, September 23, 2007
Danger lurks as Bank's credibility suffers
Posted by David Smith at 09:00 AM
Category: Thoughts and responses


Waking up on Thursday to the news of a high-profile departure, my first thought was that Mervyn King must have quit. But no, it was Jose Mourinho [the former Chelsea manager for nonsporting readers], to whom the Bank of England governor must be grateful for relieving some of the media pressure on him. The Bank’s own “special one” remains in place.

This has been an extraordinary week. I don’t want to go into a blow-by-blow account of the twists and turns in the credit crisis / Northern Rock story, which we cover in detail elsewhere. But a couple of things stand out.

The first is that Alistair Darling, the chancellor, has broken his own political rules of engagement. His career has been built on invisible, controversy-deadening competence, but he suddenly found himself with more air time than he was comfortable with. If his hair was not white before, it would have turned it.

His decision to guarantee the deposits of Northern Rock savers, and by implication every saver, calmed the panic. It should have been announced first thing on Monday, having been agreed in principle the previous day but Darling, so far, has emerged pretty well, and with a higher profile.

What about King? Despite a combative performance in front of the Commons Treasury committee, when he blamed regulatory and legislative limits on his freedom of manoeuvre, his credibility has been damaged. Sir John Gieve, one of his deputies, faced the worst of the committee’s flak.

Will King resign? I would be surprised. Will he get a second term when this one expires next year? He has had the equivalent of a football manager’s vote of confidence, Downing Street backing - often the kiss of death. Will he want to carry on? The appeal of a quieter life must be considerable. It could be that we get a Mourinho-style “by mutual consent” departure, though I think it more likely he will carry on.

There are two main charges against King. The first is that he underestimated the scale of the problem. His comments at the August 8 inflation-report briefing, in which he welcomed the repricing of market risk and insisted “it’s not an international financial crisis” speak for themselves. So does his insistence then that “I don’t think there’s any real evidence here of a fundamental challenge to the macro-economic outlook”.

For many of those watching, this was extraordinarily complacent.

The other criticism is over last week’s U-turn, or “swerve”, in providing longer-term liquidity to the markets against a wider range of collateral. Done earlier, could that have saved Northern Rock from having to seek “lender of last resort” help from the Bank? The Bank says no, others say yes. A governor who played it by what he saw as the book and then presided over the first big run on a British bank since the Victorian era still has a lot of questions to answer.

Though this is the Financial Services Authority’s responsibility, analysis by Paul Ormerod and Bridget Rosewell of Volterra Consulting shows that the widening of money-market spreads that undermined Northern Rock can be expected to happen more frequently than the FSA’s stress-tests assume.

The Bank’s supporters worry that the credibility damage will spread to monetary policy. The Bank has maintained public and market confidence in its ability to keep on delivering low inflation. If that is undermined, we are in trouble.

Built on this is another fear. Will the Federal Reserve’s half-point cut in interest rates last week take us down the wrong road, as central banks did towards the end of the past two decades? The relaxation of monetary policy after the October 1987 stock-market crash helped give us the inflation of 198990. The rate cuts after the LTCM crisis of autumn 1998 gave us the final madness of dotcom boom and bust.

As things stand, I can think of as many reasons not to cut UK interest rates as to do so. The economy is not falling off a cliff; retail sales, the money supply and mortgage lending were strong last month. The global economy is buoyant and continues to push up the price of oil and commodities. Would the Bank, in cutting at the prospect of weakness in the housing market, be engaging in a monetary policy version of the “moral hazard” King is so concerned about?

On the other hand, money-market interest rates remain high in spite of last week’s swerve, and represent a tightening of monetary policy, particularly for the 60% of business borrowing directly linked to Libor (the London interbank offered rate). Inflation is below target and wages growth benign. Most forecasters are revising down their predictions of growth for next year in the light of the credit crisis.

We shall see. The issue will come to a head when the Bank undertakes a review of its forecasts for its November inflation report. But this is a fast-moving situation.

While King and his team struggled, somebody else has not covered himself in glory in recent days. Was it sensible, as queues besieged Northern Rock branches, for David Cameron to attack the government for building economic growth “on a mountain of debt”?

Government debt as a share of gross domestic product, just over 38%, is lower than the 43.6% it was when the Tories left office. Even if you add off-balance-sheet financing, Labour has not got back up to the level it inherited.

What about household debt? It has risen, to £1,355 billion, just under the UK’s annualised GDP in the second quarter. This has fuelled the house-price boom but it has not been responsible for consumer-spending growth. Between 1997 and 2006 the level of household disposable income rose by £276 billion, while consumer spending rose £293 billion; the rise in spending has overwhelmingly – 94% – been driven by rising income.

Cameron would have been the first to attack Labour if it had reimposed controls on lending, accusing it of old-style dirigisme.

Conservatives are supposed to believe people are the best judges of their own decisions. Voters already appear to think that Cameron is a political opportunist. He does his best to reinforce that view.

PS: My reference last week to the fact that UK house prices are not 11 times average earnings, not much more than half that, brought a flood of responses, some quite rude. A disturbing number of people believe it. Let me set the record straight.

According to the Halifax, the house price-earnings ratio in June was 5.79. This is based on the Halifax’s average house price, £197,750, and its calculation for male full-time average earnings, just over £34,000, the traditional measure used to calculate the ratio.

Let me allow slightly higher numbers. Male full-time earnings were £30,763 in April last year. Uprating by 4% with the average earnings index gives £32,236. The government says average house prices were £211,341 in the second quarter, giving a ratio of 6.5. Taking male and female earnings, the denominator is £29,300 and the ratio just over 7.

How about median earnings? In April 2006 the median was £23,244 a year. To be statistically pure you need the median house price, £166,000 in England & Wales in 2006, on Land Registry data. That gives a 7.1 house price-earnings ratio. Against male earnings, £25,324, it is 6.5. These figures are high but they are well below 11.

From The Sunday Times, September 23 2007