Sunday, December 21, 2008
Transmission mechanism stuck in reverse
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Normally at this time of year you struggle to drum up interest in the events of the past 12 months, attempting to inject a bit of excitement. This time, there is no need for any artificial injections. This year has changed everything.

When the dust settles we will have a very different economy. Recessions come to an end, and history tells us this one should after four or five quarters, but its legacy will be more economic instability than we have been accustomed to. After a 16-year “nice” (non-inflationary, consistently expansionary) run, the future looks more uncertain, even when the upturn comes. More on this in coming weeks.

Investment banks that once ran the financial world are either no longer running it or have turned into shadows of their former selves, large parts of their business model broken. Banks in general, apparently built on solid foundations, proved wobblier than the Millennium Bridge. Building societies have a long history, but demutualised societies proved to be a will o’ the wisp. Northern Rock showed the way to their demise as independent banks.

Government intervention and support, for three decades regarded as off limits, and latterly as something only the North Kor-eans did, made an extraordinary come-back. Without it we might not still have a banking system or even a partially functioning global financial system. Zimbabwe’s empty shelves and financial collapse would have become the norm.

Then there are the central banks. Who would have thought they would have cut interest rates so much, in effect to zero in the case of the US Federal Reserve, 2% and falling for the Bank of England? And, having done this, for the debate to be about what additional monetary action would be needed to boost the economy?

We used to be in a world in which, if investment bankers ran finance, central bankers ran the economy. Small touches on the interest-rate tiller had a big effect. Until we had something bigger to ponder there was a debate about whether a quarter-point cut by the Bank in August 2005 produced the last leg of the housing boom.

Now things are different. There is, as the Bank put it in this month’s minutes (when the monetary policy committee voted 9-0 to cut from 3% to 2%) “uncertainty inherent in the transmission mechanism”. The Bank cannot be sure what the effects of its actions are – whether even dramatic rate cuts will have any impact.

The Bank has yet to produce the data for November, but until the end of October its gradual rate cuts had had little effect on borrowers. Average interest rates faced by companies and mortgage borrowers were higher this autumn than in the summer of 2007, despite a 1.25 percentage point Bank rate cut in the intervening period.

We should not forget that the really big rate cut, from 4.5% to 2%, happened in the past six weeks. One key question is whether that is passed on in lower rates to borrowers; it has triggered a big fall in money-market rates. Another is how long, assuming it is passed on, it takes to have an effect. Monetary policy is always at its riskiest during the period before the lag kicks in.

A reduction in interest rates on existing borrowings is worth having. What is also needed is for money to flow through to new borrowers and those replacing existing borrowings. Sir James Crosby, in his report for the Treasury, pointed out that £160 billion of mortgage-backed securities will come up for redemption in the next two years, at a time when issuing new ones will be hard. That is why the talk is of quantitative easing. Normal monetary easing is about reducing the price of money, quantitative easing is about increasing its quantity.

Analogies about turning on the printing presses are not particularly useful. If it was that easy, central banks would do it. Literally printing money would merely fill up the cash machines and, carried to extremes, bring echoes of the worthless “wheelbarrow money” of Weimar Germany.

So quantitative easing is a bit more complicated. The money-supply numbers are subject to huge distortions because the banking system is not operating normally, but Simon Ward at New Star calculates that, after stripping out these distortions, “broad” money-supply growth is negative.

Those with memories of the Thatcher government’s monetarist experiment will remember its concern about excessive broad money growth, one reason being that the public sector was borrowing too much. It still is – public sector net borrowing in the first eight months of the 2008-9 fiscal year was £56 billion – and one easy way to boost money supply would be to “underfund” this borrowing, selling fewer gilts than needed to cover it.

That would not solve the underlying problem of strangulated bank lending. A good suggestion, set out in a paper by Kathleen McElvogue and Alistair Milne of Cass Business School (, is that governments should offer, on commercial terms, insurance against systemic risk in credit markets. It is the fear of this risk that has frozen credit markets and constrained lending. Crosby proposed a local version for new UK mortgage-backed securities.

Central banks have plenty of quantitative easing weapons in their armoury, buying government bonds, asset-backed securities or other instruments, notably from the banks, with the aim of providing them with additional capacity to lend.

You can lead a horse to water but not necessarily persuade it to start glugging. In April, I suggested that direct lending by government might have to be part of the solution, and that seems even more relevant now. We have state-owned banks, such as Northern Rock, and we have majority-owned banks like Royal Bank of Scotland (RBS). So far, Northern Rock has been running down its loan book, with damaging consequences, while the approach to RBS has been hands-off. That cannot last.

Some will say the last thing government should do is force banks into “uncommercial” decisions. That’s a bit rich considering the banks’ own decisions in recent years. Their caution and funding constraints mean we have gone from feast to famine.

Others say we should just lie back and accept our punishment, because current problems built up for decades. But, while Bernard Madoff may have been scamming investors since the 1970s, in general we are talking about problems of recent origin.

US sub-prime lending only really took off over the 2003-6 period; the UK banks’ funding gap only reached problematical levels three to four years ago, and other examples of excess, such as leveraged buy-outs (all those private-equity deals), only got out of hand in 2006-7.

These problems of recent origin can be fixed, though it is not proving easy. What we should not do is give up. The transmission mechanism is damaged but this is no time to scrap the car.

PS: An old friend was made redundant last week, adding poignancy to grim unemployment figures — the claimant count rose 75,700 to 1.07m last month. The mood change since September, the worst phase of the banking crisis, is taking its toll.

Charlie Bean, deputy governor of the Bank, thinks even firms not directly pressured to cut staff are doing so for fear of what lies ahead. This kind of loss of confidence has been a feature of the crisis. Getting it back is a priority for 2009.

Anyway, apart from wishing readers an excellent Christmas in hard times (we should all dip into Dickens), let me encourage you to come back next week. There will be the annual forecasting league table, which will be embarrassing, and a chance for readers to show they can beat the professionals.

From The Sunday Times, December 21 2008