It is not news that the British economy is in recession, as the (quite unreliable) official GDP data indicated yesterday, when a 0.5 percent decline was recorded for the third quarter of 2008. It has been clear since the beginning of the summer of 2008 that there was going to be a broadly based downturn in all the key indicators of aggregate economic activity – output, sales, orders, employment, vacancies etc.. What is new is the unexpected steepening of this decline in activity since August. The economy appears to be falling off a cliff.
It is clear that the major culprit in the recent sharp deterioration of the real economy has been the collapse of the private banking sector in the UK and much of the rest of the north Atlantic region, and the associated virtual disappearance of access to external finance for many households and non-financial enterprises. The lucky ones that can still access banks and capital markets do so at much higher interest rates and against much more stringent collateral and other non-price conditions.
The collapse of private banking affects the US (but not (yet) Canada) and continental Europe much as it affects the UK. The market liquidity and funding liquidity crisis has also hammered most emerging markets, including the BRICs. In addition, many of the key emerging markets turned out to have big domestic financial skeletons in their closets, acquired during the earlier decade of excess.
The result is a marked slowdown in global growth which provides the UK with a second major negative impulse to economic activity. This weakening of global demand has had one favourable consequence for the UK: oil and other commodity prices have collapsed. The US dollar price of oil alone is down by around 60 percent from its peak a year ago. This provides commodity-importing countries with a positive terms-of-trade-shock and reduces short-term and medium-term inflationary pressures – it constitutes a positive supply shock. Sterling’s precipitous decline (10 percent against the US dollar in the past week, 18 percent against the yen and an all-time low against the euro) has not had much of a buffering effect on the British net trade balance thus far.
The ruinous contribution of Gordon Brown
Despite the favourable supply shock provided by declining commodity prices, theUK economy is tanking fast -faster probably than the US and the other European nations. The main reason is that the British economy is uniquely vulnerable to a credit crunch, because of the extreme leverage of its household sector and the dreadful state of its banking sector.
As regards the household sector, even the US, where the ratio of household debt to annual disposable income peaked at around 140 percent, does not match the UK’s 170 percent. The average for the continental EU countries is around 100 percent. The house price boom/bubble in the UK, which was stronger than that in the US, and which ended more recently, was a key driver of this excessive household leverage. With house prices only halfway down to a trough that is likely to be around 30 percent below the last peak, UK household balance sheets look simply awful. In the rest of the old EU15, household finances are on average less unsound than in the UK, although there are notalble individual exceptions in Ireland and in Spain.
The UK banking sector, now partly owned and implicitly wholly underwritten and guaranteed by the UK government, is in bad shape partly because of poor investment decisions, partly because it is exposed to the closure of many key wholesale markets, partly for normal cyclical reasons, but mainly because of past regulatory failures. Some of these regulatory failures affect all banks with significant border-crossing activities, British and non-British. The Basel II accord permitted large internationally active banks to skimp on capital in exchange for better risk management and greater market discipline through enhanced transparency and openness. We got the skimping on capital. We also got worse risk management (including reliance on banks’ internal risk models) and less market discipline during the boom years. Market discipline is inversely proportional to the degree of euphoria in the market. We got none during the boom. We get far too much of it during the bust.
Basel II did increase transparency to some extent by being less tolerant of off-balance-sheet activities and vehicles, but this did not compensate for the vulnerabilities introduced by the assumptions embodied in the Basel II arrangements that (1) banks knew what risks they were taking on and (2) that banks would truthfully reveal that information if they had it.
It is worrying as regards future transparency, that regulators appear to have agreed on a weakening of mark-to-market accounting and reporting. The right way to deal with the pro-cyclical effects of mark-to-market accounting and reporting would have been continued application of strict mark-to-market principles combined with regulatory forebearance as regards the actions banks would have to take as a result of the strict application of mark-to-market principles when there is systemic market illiquidity. Once again, the road chosen grants greater discretion to banks to abuse private information in the pursuit of management interests, and at the expense of systemic stability.
But in addition to this global relaxation of constraints on bank balance sheets, the UK, under Gordon Brown as Chancellor of the Exchequer, became the leading protagonist, often even ahead of the USA, of self-regulation wherever conceivable for banks and other highly leveraged institutions, and at most light-touch regulation (i.e. soft-touch regulation) where self-regulation blatantly made no sense. The UK under Chancellor of the Exchequer Gordon Brown continued the tradition established by the Conservative Party since Margaret Thatcher of opposing any strenthening of the global coordination of national financial regulatory regimes. Brown, like the Conservative Chancellors before him, opposed with special vehemence, and and all initiative for common regulation, let alone supranational regulation in the one arena where it could have been delivered most easily: the EU.
The UK, under Chancellor of the Exchequer Gordon Brown became a lead player in the regulatory race to the bottom through which nations tried to poach financial service industry activity from competing national centres or to stop their own financial enterprises from relocating abroad.
It is surprising that someone who was such a compulsive micro-tinkerer in the domestic labour market, in the domestic tax, transfer and subsidy structures and in the regulation of industries producing mainly non-traded goods and services, would when it came to financial markets and institutions, become such a devoted disciple of Alan Greenspan – the guru of self-regulation by financial institutions and of deregulation of financial markets and activity across the board. Indeed, Chancellor Brown even appointed Greenspan a special Adviser when Greenspan retired from the Chairmanship of the Fed early in 2006.
Mr. Greenspan, much to his credit, has the intellectual honesty to admit that he was wrong in his belief that financial institutions and markets could largely be left to regulate themselves. “I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders,” Greenspan told a Congressional hearing on Thursday, October 23rd. He also admitted to having been wrong in opposing regulating credit default swaps. His testimony also contains the remarkable statement that “This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria.“ I know of only one comparable admission of the comprehensive failure of one’s life-long view on how the economy works. It is Janos Kornai’s recognition of the failure of market socialism as a superior halfway house between central planning and a liberal market economy.
But there have been no comparable mea culpas and intellectual recantations from Gordon Brown, the chief British cheerleader for financial deregulation and for self-regulation or soft-touch regulation for financial institutions and markets. The day you hear a political figure say: “I am sorry; I made a mistake because I had the wrong understanding of how the world works” is the day we will be skating in hell on natural ice.
The second reason Gordon Brown’s stewardship of the UK Treasury has turned out to be so costly to the UK economy is that, after the first term of the New Labour government (during which budgetary policy was consistently tight), he switched to a relentlessly expansionary fiscal policy in New Labour’s second term. This was cyclically appropriate when there were signs of the real economy softening (there were few of those until recently) and cyclically inappropriate, that is, procyclical, when the level of economic activity was higher than what was warranted by the path of potential output. This was most of the time. As a result the economy is faced, right at the onset of the recession, with an unsustainable structural fiscal deficit. The level of the debt (gross and net) is still lower than in most other European countries, unless one were to include the debt of Northern Rock and of Bradford and Bingley (the 100 percent state-owned banks), of RBS (close to 60 percent state-owned) and of Lloyds-TSB and HBOS (with large state minority stakes of around 40 percent). Including the debt of the (part-) nationalised banks in the public debt total but not their assets would amount to a silly accounting game and would greatly overstate the extent of the deterioration in the public finances, serious though this is.
Even without getting steamed up about the nationalised bank debt, however, the British structural deficit is a cause for concern. For normal cyclical reasons, the operation of the automatic fiscal stabilisers will increase the budget deficit during the next few years. In addition, because the current recession threatens to become a monster, further discretionary fiscal stimuli are expected and appropriate.
But the effectiveness of debt-financed discretionary spending increases or tax cuts depends on the confidence that the domestic and international capital markets have in the capacity of the British government to cut spending and raise taxes in the future, when the economy starts to recover. Based on the experience of the past seven years, that confidence level should be close to nil. When markets fear that a government may not be willing and able to run sufficiently large primary (non-interest) surpluses in the future, when times are good, they will become sceptical about the creditworthiness of that government. Default risk premia on that government’s debt increase and credit default swaps on that government’s debt will become more expensive.
At the moment, fear and risk aversion in the financial markets are still at unprecedented levels. And that fear is mainly focused on private counterparty risk (default risk). For many emerging markets, however, CDS rates for sovereign debt are high and rising and default risk premia on emerging market sovereign debt are rising fast. Closer to home, default risk premia on Iceland’s sovereign debt are sky-high and don’t tell the full story: the Icelandic government has been rationed out of the international capital markets and requires the support of an IMF programme and of its Nordic neighbours to avoid an outright default.
At some point in the not too distant future, possibly even this year and certainly by the middle of 2009, UK government debt will no longer benefit from the flight to quality that has thus far kept the rates on Treasury bills and gilts low. Sovereign debt rates will begin to rise in the UK not just because there will be vast issuance which could cause the risk-free rate to rise, but because of rising perceptions of default risk.
Given Gordon Brown’s ruinous fiscal and financial stability legacy, Paul Krugman’s question in his October 12 New York Times column, “Has Gordon Brown, the British prime minister, saved the world financial system?”, can only be answered one way: no he has not. He has left a ruinous legacy of financial instability and lack of fiscal restraint at home. He has been one of the principal cheerleaders for the competitive international deregulation of international financial markets and of border-crossing financial institutions. He is one of the fathers of the crisis. I am pleased he did not stand in the way of Chancellor Darling’s partial remedy for the worst of the local manifestation of the banking crisis in the UK.
The capital injection into the UK banks announced by the British authorities on October 8, 2008 – which was the subject of Krugman’s October 12 column – is indeed an essential component of a sensible recovery plan for the UK banking sector. It was late and is still too little, but it was better than what had been achieved till then in many countries – certainly better than what was on offer in the US through TARP as then construed.
But far from being the decisive leader of the West in recapitalisation matters, the UK too was playing catch-up. On September 29, the Belgian, Dutch and Luxembourg governments each took 49% equity stakes in the banking operations of Fortis (a large banking and insurance consortium) in each of these three countries. This was all the more remarkable, because it involved cross-border co-operation. The deal was modified within a week, with the Dutch state taking 100% of the Dutch operations of Fortis and the Dutch rump of ABN-Amro, which was owned by the Fortis Group.
If the Benelux are considered too small fry to be interesting (even though their banks certainly are big enough to be interesting), then the 3-country co-ordinated capital injections into Dexia on September 30, which involved the French, Belgian and Luxembourgese authorities, also pre-dated the British bank rescue plan.
The UK plan was put together by Alistair Darling, the current Chancellor of the Exchequer, and his officials in the Treasury, with a little help from the Bank of England, the FSA and some private sector consultants. Gordon Brown took no role in its genesis. A generous-minded (or naive) observer would credit Gordon Brown with recognising a good thing when he sees it and throwing the political weight of his prime ministerial position behind it. A cynic might argue that Brown recognised the merits of the plan and decided to steal the Chancellor’s thunder by claiming the Darling plan as his own. There are, of course, times when the global and national interest coincide with the personal interests of a Prime Minister fighting for his political life. This may have been one of these times.
Back to UK interest rates
What does all this imply for the desirable future path of the UK official policy rate? Inflation continues to be high (at 5.2 percent per annum for the CPI index) and well above the target of 2.0 percent per annum. Meeting the inflation target is the overriding objective of the MPC. Only subject to the inflation target being met is the Bank of England mandated to pursue all things bright and beautiful, including growth and employment. A looming recession, however deep and long-lasting, is no excuse to subvert the Bank of England’s price stability mandate.
The level of GDP at the end of this year could be a full percentage point or more lower than the central projection in the Bank of England’s latest Inflation Report, published on August 8, 2008. The output gap is collapsing, as actual output falls and potential output rises because of declining real energy prices. There are also price level effects of the decline in commodity prices, which will manifest themselves as a temporary decline in the inflation rate, for any given level of the output gap. The only respite for the economy has come from the collapse of sterling, which provides a boost to the internationally exposed sectors of the economy. It will also, of course, put upward pressure on the price level, which will manifest itself as a temporary increase in the rate of inflation, for any given output gap.
My ‘central projection’ for UK CPI inflation has shifted south quite dramatically since the last inflation report, as a result of the developments just described. They call, in my view for an immediate cut in Bank Rate of between 100 basis points and 150 basis points, if inflation is not to undershoot its 2 percent target over horizons at which the MPC can hope to influence it.
There is only one material risk to the inflation target associated with a cut in the policy rate of 100 basis points or more. This is the risk that a cut of such magnitude – rates have never been cut my more than 50 basis points during the Bank of England’s period of independence – would trigger a further collapse of sterling which would, through import prices and through the prices of internationally tradable goods and services generally, give a temporary but strong boost to the inflation rate.
The reason I would go into the rate setting meeting expecting to participate in a decision to cut rates by somewhere between 100 and 150 basis points, is that I am not at all convinced that the most likely response of sterling to a rate cut of such magnitude would be a sharp decline in its value. Conventional economics of the type I still teach when they let me implies that, holding constant the exchange rate risk premium, an unexpected cut in the policy rate (not accompanied by equivalent unexpected hikes in future rates) would indeed cause a depreciation of sterling.
But during my time on the MPC, I have learnt to give up trying to treat the exchange rate as either endogenous to the decisions taken by the MPC or as predictable. Instead, I now think of the exchange rate as a rogue elephant: unpredictable, dangerous and to be treated with respect, if not with fear; not something to be manipulated or managed by the hunter, camera-toting tourist or monetary policy maker.
It is not an argument against a cut of 100 basis points or more, that a cut of such magnitude is not expected by the markets. First, by the time the next MPC meeting rolls around on November 6, the market may well expect a much larger cut than the 35 or so basis points priced in on Friday, October 25. Second, while it should never be the purpose or intent of the MPC to deliberately wrong-foot the markets, if the market’s expectations make no sense to the Committee, market views should not be viewed as a constraint on action. The MPC should, of course, determine whether such a rate surprise could have significant impacts on macroeconomic and financial stability. I consider any material macroeconomic or financial stability impact extremely unlikely. There would be massive redistributions from those who are long rates to those who are short rates, but that’s all in a day’s work.
There is also no argument in support of gradualism for its own sake – the ‘if it can be done with two 50 basis point cuts, don’t do it with one immediate 100 basis point cut’ approach to policy making. Many central bankers appear to believe the world is convex, which implies the policy prescription: when in doubt, smooth it out. I am agnostic on the convexity or linearity of the operating environment of the monetary authorities. Fear of reversals (having to raise rates at the next meeting when you have just cut them) is an even more dominant character trait of central bankers than their preference for gradualism. While I would never plan to reverse myself at the next meeting, I would, in the current extremely unpredictable environment, be quite happy to live with significant odds of an imminent policy reversal . Like Keynes, if the facts change, I will change my mind and may change my actions as a result. The nice thing about interest rates is that there are no instrument costs associated with moving them more rapidly or with changing their direction of motion.
There is only one kind of new information that could emerge between now and the date of the next MPC meeting that could cause me to change my mind about the need for at least a 100 basis points immediate cut in Bank Rate. That would be a sharp decline in the Libor-OIS spread at 3 months maturity and longer. Libor is the unsecured interbank lending rate. The OIS (overnight indexed swap rate) is the fixed leg of an interest rate swap whose variable leg is the rate at which the central bank lends (secured) overnight, compounded over the appropriate period. It is a measure of the market’s expectation of the official policy rate over the relevant maturity. In the chart below, I show the spread between 3-month Libor and the 3-month OIS. It represents an unobservable mixture of liquidity risk and bank default risk perceptions.
Source: British Bankers Association, Bundesbank, Federal Reserve, Reuters.
When the Libor-OIS spread went from about 15 or 20 basis points before August 2007 to around 100 basis points in the Autumn of 2007 and stayed stubbornly at the 80 basis points level until the summer of 2008, we knew there was something deeply wrong with the banks and with key financial instruments and markets. When sterling and euro spreads shot up to 200 basis points in September 2008 and dollar spreads reached more than 350 basis points it was clear that this was the end of private banking and financial capitalism as we had known it.
Libor matters also because many loans to households and non-financial businesses are priced off it, especially three-months Libor. The chart also makes it clear that, to the extent that 3-months Libor is a good measure of the marginal cost of funds to households and non-financial firms, there has not been a 50 basis points cut in effective interest rates (what the coordinated central banks delivered on Wednesday 8th October) but a 100 basis points increase in the UK, a rather smaller increase in the euro area (which has consistently had the smallest spread of the three countries) and a 150 basis points increase in the USA.
On those grounds alone, one could justify at least a 100 basis points cut by the MPC next month. To actually bring the marginal cost of funds down significantly below the August 2008 level, a 150 basis points cut would be required. Should the Libor-OIS spread, and the associated marginal cost of funds to households and non-financial enterprises, come down significantly between now and November 6, the case for official policy rate heroics would be correspondingly reduced.
But absent material help from the Libor-OIS spread, now is the right time for constructive panic. If not now, then when? So let’s panic with deliberation and determination, by implementing a larger-than-expected cut in Bank Rate of at least 100 basis points. Activists of the world – unite! You have nothing to lose but the respect of the gradualist Grinches that, regrettably, have always made up the majority of the central banking profession.