Sunday, January 18, 2009
Scanning the horizon for an exit strategy
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


Just to demonstrate how glamorous this job is, last week I squashed into a crowded lecture theatre at the London School of Economics, my view obscured by a television cameraman, to see Ben Bernanke, chairman of the US Federal Reserve.

Visits by Fed chairmen here are rare. The last I experienced was Alan Greenspan's in 2002, when he opened the Treasury's new headquarters and got an honorary knighthood "for services to global economic stability". No sniggering at the back. On that occasion, I sat through two speeches, though I cannot remember either.

Anyway, the Bernanke speech is fresh in my mind and was interesting in a number of respects. One was his listing of the "powerful tools" the Fed still has at its disposal despite zero interest rates. He chose to put most of these things under the heading of credit easing rather than the quantitative easing discussed here last week, but the distinction is not one to concern us.

What America does is important. Peter Spencer, professor of economics at York University and economic adviser to the Ernst & Young Item Club, points out that most recycling of global savings from saver economies to borrower countries is through dollar markets. So until these return to normal, ours will not either. "Credit will stay very tight in the UK until US interbank markets spark back into life," he writes.

That does not mean we can leave it all to America and Bernanke's "toolkit". However, the other interesting thing he said was the need for a credible "exit strategy".

Assuming near-zero rates are not normal, how do you get back to normal without stifling the recovery when it comes? That, notwithstanding business minister Baroness Vadera's credit-market "green shoots" remark last week, which she quickly dosed with weedkiller, is a way off and is the easy bit.

The bigger question is how you get back the hundreds of billions of taxpayers' money or guarantees. We have not seen the end of these, with the Treasury hard at work on Crosby-style guarantees for new securitisation issues, official "wrappers" around new corporate bonds and other measures to deal with "toxic assets", which we should hear about tomorrow.

I know people are confused by these very big numbers, so let me break them down. Most straightforward are those associated with the government's fiscal stimulus, the temporary Vat cut and the rest, over which so much political heat is being generated.

According to the Institute for Fiscal Studies, the government's giveaway was worth 25 billion, split between the 2008-9 and 2009-10 fiscal years. After that it would raise taxes and squeeze public spending, mainly the latter, to get back 38 billion.

Even with this the message is that it is a fast way down and a slow way back. The Treasury does not expect the budget deficit, which it thinks will hit 8% of gross domestic product in 2009-10, to get below 3% of GDP a barely acceptable figure until 2013-14, which is why I have argued for more aggressive spending cuts.

These things can turn round. Aggressive tax increases by Norman Lamont, Ken Clarke and Gordon Brown, coupled with the tight Tory control of public spending Labour maintained for the first couple of years in office, saw the deficit come down from 7.7% of GDP in 1993-4 to just 0.7% four years later. The important thing is not to get locked into permanently large deficits and rising debt as Japan did in the 1990s.

What about the banking rescues? These are more complex. So far we have had a 37 billion recapitalisation of the banks by the government, 9 billion in the form of 12% preference shares. We know from Lord Mandelson, the business secretary, that the terms of that recapitalisation may be revisited as the credit guarantee scheme (CGS), a second aspect of the rescue, was in December. There may be a need for another injection of taxpayer capital.

The CGS, government-backed guarantees, for a fee, against lending, has a target of 250 billion, of which about 100 billion has so far been taken up. Without it, despite talk of the rescue being ineffective, things would be a lot worse. On top of this, the Bank of England is providing up to 200 billion of short-term liquidity to the banks.

Last week there was more the Mandelson announcement of a 10 billion working capital scheme, intended to operate as a 50:50 partnership with the banks to guarantee 20 billion of such capital, plus other measures directed at small firms. There is, as I say, more to come.

How do we get down from all this, without leaving taxpayers lumbered for many years to come? It is important not to confuse apples and pears.

The 37 billion recapitalisation is real money which taxpayers will only get back when the stakes in the banks are sold off. In the case of Sweden in the early 1990s, which recapitalised and in many cases nationalised its banks, and took toxic assets off their books, it took 4-5 years for the government to sell off most of the assets, though mostly at a profit. There was still, however, a net cost to taxpayers.

The 250 billion CGS does not mean 250 billion of direct support and, if the terms of the scheme have been properly structured, should not result in taxpayer losses. Even so, the guarantees will run until 2014.

Least troublesome should be bank liquidity. The existing Special Liquidity Scheme expires at the end of the month, but this does not mean the end of Bank liquidity.Once markets return to something like normal, which they will do, the Bank will be able to withdraw quietly from this role.

Other aspects of the policy response to the crisis will, as noted, be around for some years. Financial crises take time to cure. A paper, Is the 2007 US Sub-Prime Financial Crisis So Different, by Carmen Reinhart and Kenneth Rogoff, the latter former chief economist at the International Monetary Fund, points out that the average GDP drop after crises is 2%, rising to 5% in the worst cases, which leaves economies hobbled by below-trend growth even three years later.

The challenge is to ensure they are not a millstone round the economy's neck as the recovery comes and not to get into generalised state support for the economy. Part-nationalising banks is one thing. We do not want to nationalise the car industry, even in part. We have been there before.

The Item forecast, gloomy about the short term, is fairly upbeat about the longer term. "If, as we assume, these policies work, we will move next year from recession into a decade of economic rebalancing rather than a decade of deflation," said Spencer. We have to hope he is right.

PS: Are lower interest rates better for savers? It seems a daft question, but let me revisit a piece of analysis by Peter Kellner, president of pollsters YouGov and an economist in his younger days.

Compare two situations, both of which have the same "real" interest rate of 2%. One has the interest rate on savings at 5% and inflation 3%. The other is a 2% saving rate and zero inflation.

In the first case, a basic-rate taxpayer is left with 4% after tax and 1% in real terms, while a higher-rate taxpayer is cut back to 3% and a zero real interest rate. In the second case, where inflation is zero, actual and real rates are the same 1.6% for basic-rate taxpayers; 1.2% for those on higher rates. Lower interest rates really are better for savers.

We have not got zero inflation yet. This week should see a fall to about 2.5%, so on a backward-looking basis many savers are suffering negative real rates. Zero inflation, maybe deflation, will come later. The best outcome in theory would be zero rates, therefore no tax, alongside 2% deflation falling prices. That, however, may be a step too far.

From The Sunday Times, January 18 2008