Sunday, November 16, 2008
UK on the ropes as the Bank throws in the towel
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


These are difficult days for the Bank of England. An institution that sets itself high standards and prides itself on its dignity and decorum is getting a battering.

Gordon Brown is making political hay out of the crisis but he is not carrying the Bank with him. For years central-bank independence was his proudest achievement as chancellor. Now I get people asking whether it was such a good idea after all.

At the stormiest press conference since independence, Bank governor Mervyn King and his colleagues were last week accused of being caught with their pants down as the financial crisis turned into an economic crisis. That is not an image I want to dwell on, or can imagine being put to Eddie George, King's predecessor, but the point was clear.

The Bank has lurched spectacularly in the space of three months in terms of its view on the economy and on interest rates. On the face of it, it was not just behind the curve but out of sight.

What is the Bank's defence? The world, said King, has changed, the outlook has been transformed. After Lehman Brothers was allowed to fail in September by the American government, the global banking system came perilously close to collapse.

Many people accept these were world-changing events. Confidence was weak but dived further. The autumn has been the closest thing to a "falling off a cliff" moment we have seen in this cycle, with very sharp falls in activity. At the same time, oil and other commodities plunged.

It was not hard to find reasons for oil to fall, of which more another time, but the drop was sudden and savage. I don't want to use that quote from Keynes again, which should be banned, but the facts changed and the Bank changed its mind.

Fair enough. Nobody could have predicted the recent events and nobody did. That explains King's robustly unapologetic tone.

Incidentally, there is a case for re-examining the piecemeal moves preceding the banking rescue, including the terms of the Bradford & Bingley rescue/nationalisation, the strategy for Northern Rock and even the Lloyds TSB-HBOS merger.

I don't have a particular problem with the last of these but the B&B rescue is imposing a severe burden on smaller lenders, which have to fund the Financial Services Compensation Scheme, and it makes little sense for Northern Rock to be running down its mortgage book aggressively.

So the past two months have changed things, and the Bank was right to cut rates more aggressively than anybody expected, or hoped. Many of the armchair generals who are now most critical of the Bank were attacking it very recently for not raising rates far enough to stop inflation rising.

I do not think, however, that the Bank should get away with it entirely. There is something to criticise and for me it is a tale of the past three Augusts.

In August 2006, the Bank's monetary policy committee surprised markets by raising rates for the first time in two years. Before then, the MPC seemed comfortable to live with a rise in inflation due to higher global food and energy prices.

The prospect, though, of King having to write an open letter explaining the missed inflation target injected steel into the MPC. Bank rate carried on rising until July last year, the eve of the credit crisis. The depressing effects of those hikes were still coming through even as the economy was being hit by the start of the crunch.

The story of August last year barely needs repeating. We know there were different views in the Bank, even at senior levels, on what the appropriate response to the emerging financial crisis should be.

However, this was not like the MPC, where everyone has a vote. The governor is responsible and he took the decisions. King was concerned about the "moral hazard" implications of bailing out banks for their irresponsible lending decisions. In a minor crisis, his would have been the textbook response. In the big crisis then developing, it was like insisting the silver was properly polished as the Titanic was sinking.

Which brings me to August this year when one MPC member, Tim Besley, voted for a rate hike and the others, with the honourable exception of David Blanchflower, showed no inclination to cut.

The mistake, in fact, was made earlier. In early April, I wrote here urging aggressive interest-rate cuts, a big liquidity injection by the Bank and direct government intervention in the mortgage market to prevent a downward spiral.

We had one small cut before most MPC members got frozen in the headlights of the summer inflation surge. The Bank's special liquidity scheme was launched. Direct government intervention, though, did not come until last month, and intervention in the mortgage market is awaited, pending Sir James Crosby's report, due with the pre-budget report on November 24.

We are where we are, as they say. Where are we heading? For me the disturbing thing about last week was that the Bank appeared to have thrown in the towel.

Its forecast is not quite as gloomy as painted, implying a 1.3% contraction in the economy next year and a peak-to-trough fall in gross domestic product of 2%, slightly smaller than the recession of the early 1990s. But it was more downbeat than even a rapidly changing consensus.

You expect a Bank governor to stand up for sterling. King, while saying he would not welcome a further sharp fall, had little to say except that these things are unpredictable. On fiscal policy, he gave a pre-budget-report boost for the economy his seal of approval. More on this next week.

None of this is necessarily wrong. You get a sense, however, that the Bank has also thrown in the towel on its ability to control or predict the economy. So not much it does will prevent the recession that is now, in its view, baked into the outlook for at least the next few months.

It is still predicting a significant bounce-back for the economy, starting in the second half of next year and strengthening thereafter. In normal circumstances that would be an easy forecast to make, such is the policy stimulus the economy is receiving. But these, as the Bank keeps reminding us, are not normal circumstances.

PS: A lot of people struggle with the basics of economics, as I know from responses to these pieces on the internet. Many readers tell me they could do with a refresher. Help is at hand.

A new edition of my Free Lunch: Easily Digestible Economics, published by Profile Books, is on the shelves, updated with a new introduction about the credit crunch. Walter Bagehot, whose 19th century work on banking crises has been much in demand, makes an appearance.

There are signed copies, two, for winners of my competition. Since 1979, Britain has had seven chancellors: Sir Geoffrey Howe, Nigel Lawson, John Major, Norman Lamont, Kenneth Clarke, Gordon Brown and Alistair Darling.

All you have to do is rank them, best to worst, with a tie-breaking explanation of why you have put somebody at the top or, more likely, the bottom. Younger readers may need assistance from elders. It may be unfair to include Darling, given he has only been in the job 18 months, but that is longer than the Major tenure.

I look forward to the responses. If we get enough, there could even be a league table. Good luck.

From The Sunday Times, November 16 2008