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.

Like the US, the UK has had buoyant credit growth, huge rises in house prices, low private and national savings and a sizeable current account deficit. Like the US, it also absorbed the surplus savings of much of the rest of the world in the 2000s. It is, in short, one of the canonical “Anglo-Saxon” economies.

Yet, in many respects, the UK position is worse than that of the US. The run-up in UK house prices, for example, was much bigger than in the US. On almost any measure, housing valuations and household indebtedness are still more extreme. To take one example, at the end of 2006, household mortgage debt was 126 per cent of disposable income, against a mere 104 per cent in the US.

Moreover, the UK’s current account deficit, at 5.7 per cent of GDP in the third quarter of 2007, was bigger than that of the US. Indeed, it was bigger even than it seems. As Andrew Smithers of London-based research company Smithers & Co argues, the deficit is significantly understated by current statistical conventions. Retained earnings of direct investment are included in data on investment income, but this is not the case for portfolio investment. Since a high proportion of UK-based multinationals are owned by foreign portfolio investors, this exaggerates the UK’s net investment income. The UK’s true current account deficit may have been close to 7 per cent of GDP.

The remainder of this column can be read here. Debate from our panel of economists appears below.

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. 

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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.

The same is true of Northern Rock, a specialised housing lender that saved itself the cost of raising deposits from the public by selling its loans into the wholesale market. This was a profitable strategy until the crisis in subprime US mortgages and securitised finance undermined investor confidence. Northern Rock failed to insure itself against this contingency. Credit – or trust – fled and, with it, its business model.

The drying up of these markets ultimately forced the bank to seek help from the British authorities, who promised to provide financing. But their effort to rescue Northern Rock was the equivalent of screaming “fire” in a theatre. The public, alarmed, wanted its money back.

As the public panicked, so did politicians. A solvent government will not let ordinary depositors lose significant quantities of money. Deposit insurance is the way to eliminate the possibility. But in the UK such insurance covers only 100 per cent of the first £2,000 and 90 per cent of the next £33,000. Worse, in the case of an insolvency, depositors take their place at the back of a lengthy queue. British deposit insurance does not prevent runs from banks in trouble. It guarantees they will happen. The run was quite rational.

The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.