Sunday, April 06, 2008
Seeking a cure for the credit crunch
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


The brightest minds in central banks, finance ministries and the private sector are fully engaged in ending the credit crunch.

It will be the focus of the International Monetary Fund and World Bank's spring meetings in Washington this week. Things have moved on since their autumn gathering. Now most economists think America is in recession and "normalisation" in financial markets is a long way off.

These issues are fiendishly complicated. Few can be addressed by one country alone. When the dust settles, banks can expect to be more tightly regulated than before, because through a combination of greed and incompetence some fell down on the job.

The Financial Stability Forum will report to G7 finance ministers and central banks this week. In an interim report in February, it said: "Events have shown that the quality of risk management varied significantly among the largest and apparently most sophisticated market participants."

The regulatory response will come later. What should be happening here and now? The crunch is the result of a series of market failures. It is the job of policy to try to offset such failures. Here are some suggestions how.

Interest rates should be cut

The Bank of England's monetary policy committee has pursued a cautious line on rate cuts, steering between slowing growth and higher inflation. That has been right so far, but there is now a case for more aggressive action.

The problem is the renewed rise in money-market rates, with three-month Libor (London interbank offered rate) at nearly 6% and lenders increasing their rates when the trend for official rates is down. The Bank should cut and, if necessary, cut again, until rates across the economy are falling.

The "shadow" monetary policy committee, which meets under the auspices of the Institute of Economic Affairs, agrees. It votes 6-3 this month to cut rates, with one member, Patrick Minford, opting for a half-point reduction.

Minford and the other cutters John Greenwood, Ruth Lea, Kent Matthews, Peter Spencer and Peter Warburton had a similar message. While hard evidence suggests the economy has weakened only slightly, the tightening of credit conditions, confirmed in the Bank's own survey, points to significant downside risks and the need for action.

As Minford put it: "The Bank needs to take action to cut money- market rates (not Bank rate which is now increasingly irrelevant) by around 1%, with a further bias to easing. The aim should be to get market rates down to 5% now, ready for further falls."

Of the other shadow members, Tim Congdon and Trevor Williams had a "bias to ease", but not now. Only my near namesake David B Smith has a bias to raise rates.

The Federal Reserve has cut aggressively and will do so further. What about the European Central Bank? There is admiration for the ECB's anti-inflationary stance, so it is easy to forget it has a bigger inflation problem than Britain. Its inflation ceiling is supposed to be 2% but the flash estimate of March inflation was 3.5%, not far below the official 4% interest rate. That has happened despite the helpful effects of a strong euro. Even so, the ECB will eventually have to look through current high inflation, which slower growth will take care of, and cut.

Liquidity operations should be stepped up

As well as cutting rates, central banks must continue to flood the money markets with liquidity and against a wider range of collateral. The Bank insists it is doing plenty, and its actions compare favourably with the ECB and the Fed, though critics disagree. In the present situation you can probably never do enough. Since the crisis broke, banks have on average wanted 4.5 times the liquidity the Bank has been prepared to supply, a higher level of "cover" than usual.

Direct intervention as buyer of last resort for mortgage-backed securities

The credit crunch is a result of the parcelling up of mortgages into tradeable securities. Its continuation reflects the fact that many of these markets for asset-backed securities have stopped operating. This is market failure on a large scale.

Central banks could stand aside and wait for markets to open up again, but that will take too long. For markets to kick into life, what Bank governor Mervyn King described recently as the "overhang" has to be tackled.

This does not mean the Bank or other central banks should subsidise new mortgage-backed securities. It does mean the authorities should be prepared to mop up the overhang by taking them on to their books, and for longer than just a few weeks. Buying them at distressed prices now would allow the banks to close the books on their losses. The taxpayer should make money out of the deal in the medium term.

Direct intervention as lender of last resort in the mortgage market

I have left the most controversial until last. In the UK mortgage market, part of what is happening is that lenders are sensibly scaling back in response to a weaker market. There is, however, also an element of market failure, particul- arly affecting first-time buyers.

The number of lenders has shrunk a situation exacerbated by Northern Rock's determination to run down its mortgage book and repay the taxpayer but nobody wants to increase market share. Mortgage approvals stabilised in February at 73,000 but could fall further. The result, if unchecked, could be a downward spiral of lending. The deep housing recession the authorities are keen to avoid could become a reality.

There is nothing radical about mortgage lending by government. In the 1960s and 1970s, building societies and local government vied for mortgage-market share. The Post Office, a nationalised industry, offers a range of mortgage products in association with Bristol & West. There are small-scale official schemes for key workers and others.

The government, unlike banks, would find raising finance straightforward. The Treasury, keen to switch homebuyers to long-term mortgages of up to 25 years' duration, could do so directly, perhaps offering only long-term mortgages. Could it happen? The lenders would squeal and ministers might regard it as bit too 1970s. But there is a market failure here, and it is close to home.

PS: Despite all the coverage last week, and the presence of two former chancellors (Lamont and Lawson), a former Bank governor (Lord Kingsdown) and other luminaries, the House of Lords economic affairs committee did not answer the question it set itself. Does large-scale immigration generate significant economic benefits for the domestic population? The answer, according to their lordships, is that there is "no evidence" it does.

The committee said the government's claim of a 6 billion annual boost to GDP translated into no gain on a per capita basis, because migrants boost population.

That, however, is a static way of looking at it. As some witnesses pointed out, gains from immigration are mainly dynamic and hard to quantify. Without immigration the City would not have developed or other successful economic clusters emerged. It is hard to prove but I suspect without the pool of migrant labour the economy would have run into capacity buffers long ago.

There are legitimate questions to be raised about immigration. The government's principal population projection is for a rise from 60m now to 71m by 2031 and 86m by 2081, largely driven by immigration.

If that is right, it seems like too many for these crowded islands. If the government has got it wrong, and all we are seeing is a temporary inflow, important long-term decisions are being made on a false premise. These are important issues, which the Lords are right to put on the agenda.

From The Sunday Times, April 6 2008