Sunday, November 02, 2008
Lending window is shut but rate cuts will help
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Darling, Blanchlower and King. No, not the Spurs midfield from the double-winning side of the early 1960s but just three of the characters I bring you today.

Let me start with Alistair Darling. The chancellor devoted a long lecture, the Mais lecture at City University, to tell us two things. First, he is ready to unveil some new fiscal rules, though they are not yet finalised. Second, he is not changing the Bank of England's remit from inflation to economic growth or house prices.

Why did he tell us that when nobody had any serious expectation of any change? To remind us the Bank's existing remit enables it to respond to "difficult global forces". The government, in other words, wants the Bank to cut interest rates as much as it can. Whether such pressure can be counterproductive we will know this week. More on that in a moment.

The chancellor's keenness to get interest rates down does, however, raise the question of whether people have got hold of the wrong end of the stick on the government's "Keynesian" spending intentions.

Yes, as Darling said, the government will maintain its overall spending and bring forward some already planned capital projects where possible. That task is proving easier said than done. But this is different from unveiling entirely new programmes or projects to enable the government to "spend its way out of recession".

While borrowing will rise sharply in the recession, I do not get the sense the Treasury plans to add hugely to it with a big fiscal package, hence the emphasis on rate cuts as the best anti-recession medicine.

Which brings me on to David Blanchflower. Economists do not often get to say "I was right all along" but the maverick monetary policy committee member is able to do so, no doubt to the intense irritation of Bank of England governor Mervyn King and the other MPC members.

Blanchflower, who spends half his time in the US, has long pushed the view that Britain's economy was heading the way of America's. As he put it in a recent lecture: "I have been struck by how closely the path the UK has followed resembles that of US economy about six to nine months earlier."

He consistently argued the MPC was wrong to get hung up on a rise in inflation generated by global energy and food prices, and that it was also wrong to fret about the risks of a wage-price spiral. Such risks, in his view, were negligible.
And he has been proved right. While his MPC colleague Tim Besley was voting for higher interest rates as recently as August, Blanchflower was voting for a cut. He is the MPC's superdove, voting to cut rates at all 10 of the committee meetings this year.

He is not, however, gloomy for gloom's sake. Aggressive cuts in interest rates can, he believes, prevent an unnecessarily deep and long recession and stop inflation falling into negative territory deflation.

Modern economies are more resilient than people give them credit for and "in the medium term our economy will recover and prosperity will return".

This week he will be pushing at an open door. It will be a surprise if the MPC does not cut interest rates this Thursday, and by at least half a point, matching last month's reduction. This would be only the third time the Bank has cut by a half in the 11-year independence era. It is what the "shadow" MPC, which meets under the auspices of the Institute of Economic Affairs, expects, though some in the City think it will be bigger 0.75 points or even a full point. The question is whether the Bank wants to use all its ammo at once.

The bigger question is whether the Bank has delayed too long, to the point where lower rates are ineffective. Its own Financial Stability Report, published last week, includes the Bank's new estimate that losses on securitised credit instruments and corporate bonds since the start of 2007 are now $2.8 trillion, (1,700 billion), equivalent to more than Britain's annual gross domestic product, or 85% of the banks' so-called Tier 1 capital before the crisis.

Not all these losses will be realised, though a good half are likely to be, and not all of them will be borne by the banks. But these are huge numbers.

Also in the report are the makings of what the Bank will try to put in place to prevent all this happening again. Macro-prudential supervision, dynamic provisioning, capital insurance and leverage ratios are likely to become buzz phrases soon. Essentially, the Bank and other central banks will seek to ensure banks establish sufficient financial strength in the good times to be able to cope, without government bailouts, when things turn bad.

What struck me most about the Financial Stability Report, however, was its straightforward explanation of the adjustment the economy has to go through.

Seven years ago, Britain's banks funded lending almost entirely out of customer deposits. By the first half of this year they had a funding "gap" the amount they funded mainly from international wholesale money markets of 740 billion.

The Bank does not expect this gap to close entirely, still believing there will be a place for wholesale funding in the long term, but it does suggest it needs to narrow to 2003 levels of about 265 billion.

Achieving that over a year, which the banks might have had to do without the government's rescue package, would have required a sharp drop in lending and a very deep recession. Achieving it over three years will "smooth this slowing in lending", the Bank says, but not prevent it. There will be no return, in other words, to past rates of growth of lending.

So how do lower interest rates help? Less by stimulating new lending than by easing the pressure on existing borrowers, as long as rate cuts by the Bank are passed on by lenders. They will need to be.

PS: One of the great debates is about the impact of house prices on consumer spending. Does a fall in house prices, a record 14.6% over 12 months, according to Nationwide, cause people to spend less? Or are the two subject to similar influences, so that the crunch causing house prices to fall also hits spending?

New research from Price Waterhouse Coopers, to be published this week, suggests that high-street and other spending is directly affected by a drop in house prices. This is not just through obvious routes whereby weak housing hits purchases of furniture or carpets. It does not even rely on equity withdrawal.

The important thing about house prices, according to the PWC research, is whether changes take people by surprise. Had everybody anticipated the drop over the past year, it would have made no difference to spending. But three-quarters of the fall, PWC says, was "unanticipated", and will mean consumer spending next year will be 1.25% lower than it would have been.

Why? PWC's economists have adapted one of the basics of economic theory, which is that people's spending is based on "permanent" or long-run income. An unanticipated shift in house prices changes people's ideas of how much wealth they will have tied up in their houses over the long run think of people hoping to retire on their property equity and affects their spending now. Some people celebrate falling house prices. Retailers don't.

From The Sunday Times, November 2 2008