Sunday, November 14, 2010
How to ensure a bank lending recovery
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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An excerpt from my Sunday Times piece, available to subscribers on www.thesundaytimes.co.uk

The Bank of England is tasked with achieving 2% inflation. It is a year since inflation was below target, which it was for six months, preceded by 20 months above it. If the Bank is right, it will be at least 12 months before it is below target again.

Maybe maintaining recovery after the biggest post-war financial crisis matters more than whether inflation is 3% rather than 2% for a while. It is why, while talk of further quantitative easing - electronically creating money - beyond the £200 billion so far has died down, though not gone away, interest rates remain a whisker from zero.

The Bank, for good reason, does not provide forecasts for interest rates. It does publish the path of Bank rate implied by money markets. A year ago, markets thought Bank rate would be on its way up now. Three months ago, rates were seen rising in spring 2011. Now markets see the first move not coming until late 2011.

While the recovery is stronger than after the recessions of the 1980s and 1990s - gross domestic product is up 2.8% over 12 months - the Bank fears it will not maintain that pace. Though its forecasts suggest growth in the coming years will average about 3%, the worry is about the risks.

You can never have enough warnings that if political leaders do silly things like engage in protectionism or currency wars the world economy could be back in trouble. So King was right to fire a salvo in the direction of the G20 gathering in Seoul.

The global upturn has been much stronger than expected. In the spring of 2009, the London G20 meeting in Docklands, the International Monetary Fund predicted global growth of less than 2% for 2010. Its latest projection, with not much of the year to go, is 4.8%, then 4.2% for 2011.

To go from there to the governor’s warning that the next 12 months could be more difficult than the period we have been through would be pretty dramatic but, as I say, reminders are always useful.

Then there is the renewed outbreak of eurozone tensions, particularly swirling around Ireland. Could these hit Britain? Of course. Any new turbulence is unwelcome. Britain’s banks have a direct and indirect interest in Ireland and other eurozone economies. 7% of Britain’s exports go to Ireland.

A report this weekend from Oxford Economics warns that a chain of defaults would push first the eurozone then Britain and America back into recession. The authorities are determined to prevent any such thing happening, but the risk is there.

Then there are domestic risks. I have written a lot about whether the private sector will fill the gap left by spending cuts. The governor has rarely shown his irritation more than when responding to report s about unease in the Bank about his support for the coalition’s cuts.

King said it would be astonishing if a central banker did not support deficit cuts. Equally, it would be astonishing if there were not voices in the Bank urging a slower pace of deficit reduction.

You do not have to read much between the lines of speeches by the MPC’s Adam Posen, a student of the Japanese economy, to find it. The Royal Economic Society’s latest newsletter laments the lack of a response by members to its previous issue, in which it set out the case against the cuts. I happen to believe King is on the right track but there is no disguising deep divisions among economists on the issue.

It is another domestic risk I want to focus on for the rest of this piece. “One uncertainty surrounding the macroeconomic outlook is the extent to which deleveraging in the banking sector will continue to restrict the supply of credit,” the inflation report said.

Kate Barker, until recently an MPC member, told a Credit Suisse seminar that worries over the banks’ ability to support recovery was the main reason why the Bank may do more quantitative easing.

I will do a bigger piece on banking, armed with statistics like the fact that Britain’s biggest 10 banks have grown from 40% to 459% of gross domestic product in 50 years. There is room for debate over such figures and whether changes to the system - which the Independent Banking Commission is investigating - are needed.

For the next year or so, however, the key question is whether the existing banking structure will provide enough credit. While money and credit growth are weak, close to zero, it is not yet clear lending to business is weaker than after previous recessions. That does not mean some businesses, notably smaller ones, are not being starved of credit. But the overall picture is fairly typical of post-recession periods.

Will lending pick up from now on? If it does not, it may be for a couple of reasons. One is the unwillingness of the banks to lend, in which case the government should do what it always criticised Labour for not doing enough, press the banks harder.

The other is that the banks cannot lend because, as the Bank noted, “they will need to refinance substantial amounts of maturing funding over the coming years, including that presently supported by the official sector”.

That support, £165 billion in the Special Liquidity Scheme and £120 billion under the Credit Guarantee Scheme, will come to an end. In all, the banks have £480 billion of maturing debt to roll over in the next 2-3 years. This, handled badly, could starve the economy of credit for years to come.

It seems to me, however, that if that were the cause of an ongoing credit crunch, it would make very little sense for the Bank to try to offset it by engaging in more quantitative easing. The authorities would be taking away with one hand, by withdrawing official support for the banking system, while giving with another, through further easing.

Anybody looking at this from outside would conclude this was a silly way to proceed. The Bank, with Treasury approval, would do better to extend the period over which official support is withdrawn. Problem solved, or at least one of them.