by Peter Boone and Simon Johnson
The US government has moved dramatically, in what it argues is a comprehensive manner, to counteract serious problems in the financial system, and to reduce the risk of a serious recession or worse. Eurozone policymakers are far more reluctant to intervene. They remain inclined to handle growing bank failures on a case-by-case basis; and, while their central banks have provided liquidity, they have avoided using other fiscal and monetary policy tools. If the fortunes of the world economy depended only on the US policy response, we would predict just a fairly severe recession. The absence of any indication that there will soon be a decisive European policy response suggests we could be in for something considerably worse.
In the view that is increasingly prevalent in the US, we are not facing a Keynesian demand recession, nor the supply side shocks of the 1970s. It is a crisis of confidence very similar to the Asian crisis of 1997-98. The lesson from these events is when trust in highly leveraged financial markets weakens, there can be long and enduring repercussions across all sectors of the economy. The Federal Reserve’s implicit policy model since September 2007 appears to be tied in part to those events.
In contrast, the frame of reference for European authorities appears to be drawn from the lessons of the 1970s. They are concerned about inflation and second round effects from past commodity price rises, so they keep interest rates higher. They have not announced national programmes to bail out financial institutions and borrowers, in part, because of perceived costs relating to future moral hazard. Read more
Privatisation was one of the great achievements of the Thatcher era. But it is becoming increasingly evident that the transfer of monopolies into the hands of regulated companies that own, run and develop the assets is flawed. This is excessively costly to consumers. It is also an obstacle to investment in risky long-term assets such as airports, nuclear power , electricity and gas networks.
This is not to argue that privatisation is devoid of benefits. Where competition could be introduced into the newly privatised industry, as in the case of telecommunications, the gains were huge. Elsewhere, privatisation was the way to allow essential activities to escape from the dead hand of Treasury curbs on public investment. Private finance was more expensive, but investments were at least made. Read more
Silliness is abroad in the UK. Some are arguing in favour of a looser monetary regime. I responded to this two weeks ago (“Britain must not cut loose its anchor”, May 15). Others are even muttering in favour of joining the eurozone, now celebrating its 10th birthday. Even my colleagues on the Lex column argued last week that the UK was close to meeting the economic tests for joining. The only obstacle to entry Lex could find was political.
Lex is wrong. Whether the UK meets arbitrary tests at a particular moment is irrelevant. What is right today may be wrong tomorrow. If a country is to join the eurozone, its people must be willing to cope with the consequences forever, however unpleasant they may sometimes be. Read more
By Martin Wolf
Will sterling follow the US dollar? As Willem Buiter pointed out last week (The silver lining in sterling’s decline, January 4), this is highly likely. Movements in exchange rates are, to put it mildly, unpredictable. But this one ought to happen. It should also be welcomed. This possibility was, indeed, why the UK had to keep out of the eurozone. Read more
by Willem Buiter
The announcement that the UK Treasury had authorised the creation of a Liquidity Support Facility for Northern Rock at the Bank of England came on September 13, 2007. The Treasury’s announcement of a guarantee for all of Northern Rock’s deposits (not just the retail deposits) and most of its other unsecured credit followed on September 18. Two months have passed now, and Northern Rock is still on life support, having drawn over £20 bn from the LSF – just under 20 percent of its assets.
What went wrong and what lessons can be learnt?
(1) The Tripartite arrangement between the Treasury, the Financial Services Authority and the Bank of England, for dealing with financial instability is flawed. Responsibility for this design flaw must be laid at the door of the man who created the arrangement – the former Chancellor and current Prime Minister, Gordon Brown. The Treasury, as the dominant partner in the arrangement, also bears primary responsibility for its operational performance.
The main problem with the arrangement is that it puts the information about individual banks in a different agency (the FSA) from the agency with the liquid financial resources to provide short-term assistance to a troubled bank (the Bank of England). This happened when the Bank lost banking sector supervision and regulatory responsibility on being made operationally independent for monetary policy by Gordon Brown in 1997. It’s clear this separation of information and resources does not work.
Financial panic has hit both the public and politicians of the UK over the past week, to deliver two remarkable results: the first run on a British bank since the collapse of Overend and Gurney in 1866; and the transformation of bank deposits into public debt at the stroke of a pen. These are historic times.
How then could these astonishing events have happened? Contagion is the answer, just as it was during the Asian financial crisis of a decade ago. When Thailand announced the devaluation of the baht in July 1997, few foresaw the way the crisis would spread. Yet contagion was not random. Some countries were more vulnerable to the disease than others. Read more