The Bankers’ Dilemma

One of the slightly disconcerting things about Professor Tom Congdon of International Monetary Research is his uncanny habit of getting things right — although his recent remarks on banking, to which I wish to draw attention, are, to be fair, in line with what other commentators have said, and indeed what I have said myself on a number of occasions.
 
The received wisdom is that the current economic crisis was caused primarily by the greed, folly and profligacy of bankers, who lent money to poor-risk-borrowers, secure in the knowledge that they would be richly rewarded for any successes and profits, but would also be bailed out by the tax-payer if it all went pear-shaped.  I have separately made the case that this analysis misses the point, and that the primary failures were of policy and regulation, not of the banking industry, so I will not return to that debate here.
 
But the fact remains that a great deal of dodgy lending took place, and regulators and governments are right to call for more caution and prudence from the banks.  It is a good thing that we have seen the back of the 125% mortgage, and that 75% is more the order of the day — even if this incommodes first-time buyers and the housing market.  At the same time to provide a cushion against future crises, there are calls for banks to strengthen their balance sheets and build up their reserves.  And a third factor — banks have been given strong incentives to repay the emergency loans they have received from governments.  This is all well and good, and makes perfect sense.
 
The nonsense arises when at the same time and in the same breath, governments and regulators also demand that banks continue to lend.  In some cases they call for bank lending this year to match bank lending last year — and this at a time when demand for borrowing is reduced, as businesses and entrepreneurs pull in their horns and avoid excessive risk and excessive borrowing.
 
This brings me to Professor Congdon’s observation, and very pithy and focussed it is.  “This is becoming ridiculous.  How can banks raise capital asset ratios and lend more at the same time?  These people {i.e. the government} are barmy”.  Well said, Professor.  Our demands on the banks are self-contradictory.  They cannot do both things at the same time.
 
Professor Congdon has also had some rather harsh things to say about the euro and the ECB: “Fractures in the euro system are becoming clearer by the day”.
 
I wish it were possible to argue that Britain, with its own currency, was weathering the recession better than euro-zone countries, but at first sight that’s a difficult case to make.  We were earlier into recession and slower out of it than most continental economies, and we are weighed down by a savage level of government debt.  Many believed that the effective devaluation of Sterling (which of course would not have been possible had we joined the euro-zone) would act as a boost to exports, but at least initially, this did not seem to be occurring.
 
We need to understand why the recession hit Britain so hard, and there are two clear reasons.  First, the problem started in the financial sector, where Britain is relatively over-represented.  We were proud that our financial services sector was so dominant, but of course we were vulnerable to a financial-sector recession.  And secondly, we can thank Gordon Brown’s profligate spending.  Even Keynesians, who believe in spending their way out of recession, understand that you should not run a fiscal deficit throughout the business cycle.  Unfortunately, Gordon did not understand that.  Having been bequeathed a well-managed economy (thank you Ken Clarke) with low debt levels, he proceeded to spend like a drunken sailor.  When we needed money to underwrite the banks and to stimulate the economy, the cupboard was bare.
 
The government now faces problems with selling its debt, and the interest rates it is obliged to pay are edging up towards Italian levels.  That is not a weakness of Sterling.  It is a failure of Labour government policy.
 
These problems, serious as they are, are not directly currency-related.  Meantime, perhaps belatedly, we do seem to see some benefit from the Sterling devaluation, both in terms of balance of payments and in terms of outsourcing of manufacturing.  The BBC reports that significant numbers of UK manufacturers, who previously outsourced production to cheaper markets in the Far East or Eastern Europe, are bringing production back, for reasons that include quality, shorter supply chains, and the more competitive labour costs delivered by Sterling’s current level.
 
The problems of the euro-zone come from countries like Greece, Spain, Italy and Ireland struggling with debt while at the same time being in a currency union with radically different economies like Germany.  It is this fact that creates the “Fractures in the euro system” of which Professor Congdon speaks.  This is the fact that represents an existential threat for the euro, but which cannot represent such a problem for Sterling.  Even given the recession, we are still better off with our own currency.

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