Sunday, January 04, 2009
Two monsters battle to settle our future
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Here we are, and what a challenge it is to steer through the prospects for 2009. On one side is the reality of the credit crunch. Appropriately, given that the original film came out in 1933, and that this is the worst crisis of its kind since then, Goldman Sachs dubs this King Kong.

On the other side, for the UK, is another monster, this time one that should have a big positive impact: the combination of ultra-low interest rates, a huge depreciation of sterling — 24.7% on average between the end of 2007 and the end of 2008 — the government's fiscal stimulus and, let's not forget, the fall in oil and commodity prices. These add up to what in normal circumstances would be an unprecedented boost.

This powerful force, as lovers of Hollywood B movies will recognise, is Godzilla. The battle between King Kong and Godzilla will determine the outcome for 2009.

Let me start with Kong. One or two bankers have put their heads above the parapet. Sir Win Bischoff, chairman of Citigroup, acknowledged that bankers were "partly to blame" for the crisis. John Varley, chief executive of Barclays, said banks faced a "public-relations crisis" and should share their portion of responsibility.

Brave though these two are to break cover, to suggest the banks merely played a part in the crisis is a bit like saying Hamlet had a cameo role in Shakespeare's play. This was, and is, the bankers' crisis.

The banks lost shareholders hundreds of billions investing in instruments their managements did not understand. The attitude of bank boards had not moved on from Barings in 1995 when it was brought down by the Leeson affair — Don't ask questions as long as it makes money.

The banks failed in the most fundamental way when it came to banking business — they did not ensure their lending was based on secure sources of funding. This is chapter one, line one in the banking textbook, and they screwed up. Their failure verged on the criminally irresponsible.

Yes, banks should have been better regulated and, yes, the failure of the ratings agencies was abject but we should be clear where the responsibility lies.

And, to clear up a misunderstanding I left hanging a few weeks ago, when quoting the Liberal Democrat Treasury spokesman Vince Cable, that responsibility does not lie, in my view, with bank customers, particularly personal customers. I'll return to UK household debt in the coming weeks, to correct some important misconceptions, but it was not the job of bank customers to ask whether their bank actually had the funds to lend.

But we are where we are, and the credit crunch is still biting. The Bank of England's latest credit conditions survey shows lenders tightened availability of credit to households and businesses over the past three months and expect to tighten further over the next three. The banks, by reining back, are making the economic situation, and their own, worse.

Don't get me started on the argument, from baleful bishops or anybody else, that the last thing we should be doing is encouraging more borrowing. What we are talking about is ensuring a normal flow of credit in the economy, without which it cannot function. I am not confident the bankers understand that, which is why there is a strong case for the government to lend directly or use its influence on the sector to ensure that lending flows.

What about that other monster force, the big stimulus? The contrast between Britain, with a combination of a lower pound and lower interest rates, and the eurozone, where the effects of rate cuts have been offset by the rising euro, is striking.

Add in the real income boost from lower energy prices and, for borrowers, much lower interest rates, and the scope for eventual recovery should be formidable. Consumer spending, after all, is overwhelmingly financed from income growth.

We should not ignore the effect of such a stimulus, even when all else seems lost. Even in the Great Depression of the early 1930s, Britain had a single very bad year, 1931, when gross domestic product fell by 5.1%, before embarking on a long upturn, thanks to the stimulus largely brought about by leaving the Gold Standard.

What about this year? The dirty little secret about forecasting growth is that much of the recession is already "baked in" to the outlook thanks to the economy's performance since mid-2008. GDP fell 0.6% in the third quarter and perhaps 1% in the fourth, on its way to a probable 2.5% decline by mid-2009, which will probably be roughly the 2009 outcome, even allowing for some stabilisation in the second half ahead of an upturn in 2010.

Growth this weak will mean rising unemployment. People either quote the Labour Force Survey measure or the claimant count. I prefer the latter, which will probably rise from its present 1.07m to about 1.75m. There is little sign yet that the job market safety valve, migrant workers returning home, is helping.

Very low inflation will be a feature of 2009, with the retail prices index certainly showing annual falls for at least part of the year and consumer price inflation also likely to turn negative. I would expect the latter to end the year at 1% (that weak pound must have an impact sometime) and for Bank rate to be at a similar level. One question for the Bank will be when it feels able to start restoring rates to "normal" levels.

The big surprise could be Britain's balance of payments. I think we are heading for a current-account surplus, even if we do not get there in 2009. Revised figures show the 2007 deficit at £39.5 billion, less than 3% of GDP, and the 2008 figure looks like being no more than £25 billion-£30 billion. £20 billion or less appears on the cards for 2009.

Whether this helps sterling, we will see. My view is that the pound's fall against the euro is one of those illogical "one-way bet" market movements akin to the rise in the oil price up to last summer. Logic suggests a recovery. Goldman Sachs predicts a rise from current near-parity to 1.25 over the next few months and to around $1.75.

Anyway, that is my first stab at 2009. Many have sent in projections in response to my invitation and have another week to do so. They should be sent to my e-mail address below. Entries posted as comments on will not count.

PS: Will the Bank take us to a new interest-rate low this week, breaking into sub-2% territory for the first time since it was founded (by a Scot) in 1694?

In normal circumstances, its monetary policy committee (MPC) might wait until the seasonal data fog has lifted. That and the perception that aggressive rate cuts are not having much impact — Nationwide building society says it will not pass on further cuts to tracker customers — argues for caution.

The "shadow" MPC, which meets under the auspices of the Institute of Economic Affairs, votes for a hold this month. While two of its members, Ruth Lea and Trevor Williams, vote for a full percentage point cut and one, John Greenwood, opts for a half, the other six favour a hold this month. That does not mean they favour inaction. Their overwhelming view is that now is the time for the Bank to start unveiling quantitative easing and other "unconventional" measures to boost the money supply and slow the economy's decline. There is not space to go into the detail of the shadow MPC's array of proposals but the minutes of its discussions are available from Lombard Street Research or on this website.

Will the actual MPC follow its shadow? Maybe not. There is still a head of steam building for lower rates, and the Bank made it clear in its December minutes that it had unfinished business. Some analysts expect a full-point cut on Thursday. I think a half is more likely.

From The Sunday Times, January 4 2009