How could the Government have imagined that a Treasury announcement that
triggered a 50 to 70 per cent collapse in the share prices of the biggest
banks in Britain would strengthen the economy and stabilise the financial
system? And why did Alistair Darling repeat the blunder he made in his
initial abortive bank rescue in early October, announcing a set of policy
objectives and guidelines but failing to specify how and when they would
come into operation or quantifying the extent or the cost of this state
support?
One possible answer is that the Prime Minister and the Chancellor have left
detailed implementation of their policies to Treasury officials, whose
instinct is to dilute or delay decisions that might increase public
borrowing, interfere with the free play of market forces or put taxpayers'
money at risk. After all, this is the Treasury that resisted pressure from
the Bank of England to provide government guarantees in the Northern Rock
bank run, that tried to avoid renewing these guarantees again last October
in the near-collapse of the entire financial system post-Lehman, and that
undermined what was supposed to be a confidence-boosting tax cut last
November by turning Mr Darling's Pre-Budget Report into a terrifying
Jeremiad about future tax hikes, fiscal crises and a permanent decline in
Britain's long-term capacity for economic growth.
There is, however, a less depressing interpretation of last week's financial
events: finally, the Government has done the right thing by offering
bullet-proof insurance for all the assets in Britain's banking system. And,
just as importantly, it has promised to extract from the banks legally
binding and enforceable guarantees of specified levels of lending growth to
households and non-financial businesses. These are, finally, the right
policies to cope with the present crisis. But investors have responded
churlishly and perversely, simply because they are too impatient and do not
yet understand the Government's new-found determination to put these
policies into effect.
I believe that this second interpretation is now valid, but that there has
been a serious political failure in communicating this by the Government.
Indeed, the politician who came closest to a convincing statement of guarded
optimism over the weekend was Kenneth Clarke. As Mr Clarke explained on the
BBC yesterday, the Government is right to spend public money and offer
guarantees to deal with the financial crisis. The problem is that the
methods chosen to pump money into the economy have thus far been
“ineffectual”. “So far, the crisis is deepening and we haven't achieved the
one key objective: to get the banking system working normally again.” But
despite these policy failures, it was simply “not realistic” to talk, as
many in the media and the City have been doing, about a financial “calamity”
with Britain forced to go cap in hand to the IMF, as it did in 1976.
What the Prime Minister and the Chancellor must do, assuming that they really
are determined to implement the financial support package announced last
week, is to explain much more clearly why their policies to increase bank
lending to homeowners and non-financial companies will work and why it is
perfectly compatible with further reduction in the risks and leverage within
the banks and other financial institutions. To do this, the Government must
dispel the widespread notion that the UK's companies and homeowners have
vastly increased their debt burdens — and must, therefore, accept painful
deleveraging for many years to come.
This is simply not true. As I have explained repeatedly in this column, the
really dramatic increase in debt burdens has taken place within the
financial sector, among banks and hedge funds, not among homeowners and
non-financial businesses. In fact roughly 70 per cent of the increase in
debt to GDP ratios since 1992 in both America and Britain has been in the
financial sector. The difference between financial and non-financial debts -
crucial in implementing the Treasury's new bank-lending contracts — can be
seen in a theoretical example. Suppose a manufacturer such as GKN wants to
buy a £1 million machine tool. In the old world of traditional bank finance,
GKN would have borrowed £1 million from HSBC and that would be the end of
the matter. But since the 1990s, the brave new world of securitised
hyper-finance has managed such a transaction in a very different way. GKN
would sign a £1 million lease with General Electric Credit. GE would then
sell £1 million of bonds to a special purpose vehicle, which would fund
itself by selling £1 million of commercial paper to a hedge fund.
This hedge fund would borrow £1 million from its prime broker, which would
borrow £1 million from Barclays Capital, which would turn around and borrow
£1 million through the inter-bank market from HSBC. The net result is still
that GKN's investment is financed by £1 million of deposits at HSBC. But in
the process, £6 million of debt has been created instead of £1 million of
debt. Give or take a few trillion dollars, this was essentially the story of
the credit boom. And it has a hugely important policy implication that
almost nobody in Britain seems to recognise.
In principle, the necessary deleveraging in the British financial system could
be achieved simply by netting out the transactions among financial
institutions, with very little impact on the non-financial economy (apart
from significant but limited second-order effects of bankers losing bonuses
and jobs). Of course, such an orderly netting-out of financial debts became
much more difficult after the collapse of Lehman.
But a proper understanding of the difference between financial and
non-financial leverage still offers hope of protecting the non-financial
economy from the worst effects of a credit collapse. Yet to my surprise,
British policymakers and investors have ignored the distinction between
financial and non-financial leverage — at least until last week.
Now for the good news. Last week, Mervyn King and Lord Turner of Ecchinswell,
the new head of the FSA, gave speeches emphasising this distinction between
financial and non-financial debt and drawing the right conclusions. The
Governor pointed out that “much of the increase in debt occurred within the
financial sector [and this] means the necessary unwinding of balance sheets
could and should take place primarily within the financial sector without
restricting lending to the ‘real' economy ... And the lending agreements
which will be negotiated between Government and individual banks will focus
on lending to those non-financial sectors”. Lord Turner, in what was
probably the deepest and most perceptive analysis of the entire financial
crisis published so far, made the same point: “The huge growth of
intra-financial system leverage has a relevance to the urgent issue of
short-term macro economic management. The more that we can ensure that bank
deleveraging takes the form of the stripping out of inter-trader complexity,
and the less it takes the form of leveraging vis-à-vis the non-bank real
economy, the better.”
These statements, in conjunction with the Treasury's new bank guarantees and
lending agreements, could mean that the necessary de-leveraging of the
British financial system will at last be sensibly managed. Regulators will
force banks gradually to cut their lending to financial institutions, while
increasing credit to non-financial business and households. If this happens,
the worst of the collateral damage to the non-financial economy inflicted by
the credit crisis could soon be over.
