When ‘New Labour’ came to power in May 1997 the first thing Crash Gordon, the then Chancellor of the Exchequer, did was hand control of interest rates to the Bank of England stating that they had a target to maintain inflation at 2%. The logic being that successive Conservative governments had used interest rates as a political tool to curry favour with a home owning (mortgage owing) electorate that they had created since 1979. Prior to the owner occupier explosion created by the Thatcher Government, interest rates would have little direct impact on a great swathe of the electorate because they were in rented housing.
The logic of the decision was to take the political element out of the interest rate setting process so interest rates would be set at a level appropriate to the level of growth in the economy. Now, in order to measure the growth in the economy a full set of metrics would have sensibly been required, manufacturing order books, house price growth, unemployment levels, money supply levels, strength of sterling compared to other currencies and domestic inflation. If you think of all these metrics being instruments on a car dashboard it would be a good picture to have in your mind. What the government was to give the Bank of England was a single measurement, that of inflation. Using the dashboard analogy, this was like ripping your dashboard out and leaving just a voltmeter in place of all the other more useful stuff….. like a speedometer for example.
The Bank of England was told that they had to maintain inflation at 2%, with the stiff penalty of having to write a letter to the chancellor if the level of inflation went above 3% or below 1%. Now, the level of UK inflation is based on the Consumer Price Index, CPI, this is set by an independent body, who are essentially statisticians. They monitor the prices of a basket of typical goods, food stuffs, cinema tickets, domestic and vehicle fuel, computer games etc. The contents of this basket are reviewed periodically to ensure that it fits in with what people are actually buying otherwise the price of items such as Fish Tail Parkas would still have an impact on CPI despite the fact that nobody has worn one for 30 years. The CPI is meant to be able to give an international comparison of inflation, thus trifling things (like Council Tax and Mortgage Interest) is not included in the CPI and as we are all so painfully aware Council Tax has increased dramatically since the millennium.
Critically, one measure that is omitted from the inflation figures is house prices. This, as it turns out, had a dramatic effect on the economy. Just after Labour came to power, the rapidly growing economies of South East Asia hit something of a crisis. This was big news indeed, and stock markets around the world fell dramatically. The SE Asian economies that were affected addressed their problems by de-valuing their currencies and promoting their manufacturing base. In turn, this had a fairly dramatic effect in the UK and other Western economies. Prices of consumer electronics fell dramatically and the price of oil tumbled at one stage to below 10 USD/barrel due to lack of demand from the East. UK inflation was pushed down and allowed interest rates to remain at a low level. Business profits increased as fixed costs such as fuel fell. Interest rates being low enabled people to borrow a larger principal amount for the same monthly payment as they would have had, say 5 years previously thus lighting the blue touch paper under house prices (increasing by 10-15% per annum). But crucially, this was not reflected in the rate of inflation which stayed low because of all the cheap consumer goods that were coming in from the East.
Eventually, the principal amounts being requested and indeed required by borrowers to buy a home outstripped the supply of money that depositors had in bank accounts. That’s when bankers hit on the idea of securitised mortgages which moved customer debts off their balance sheets. These were then traded in a market (the banks had discovered alchemy) where money could never run out. They didn’t need to offer savers good rates anymore in order to draw in funds to lend to borrowers. Banks were also buying bundles of theses securitised mortgages and treating them as fixed rate bonds. These gave the banks a ‘fixed’ income at a fairly high level as some of these mortgage backed securities had sub-prime lenders at the far end of them who were paying a high rate of interest. Savers reacted to this by stopping saving and starting spending, mainly it would seem on houses, again pushing prices skyward.
Then the music suddenly stopped, those sub-prime borrowers reverted to type and stopped paying their mortgages so the securitised bonds at the other end of the mortgage stopped paying the interest and the banks were (and still are) left high and dry! The mortgage backed bonds are worthless, banks cannot sell them on and income from the bonds has dried up.
If house price growth had been included in the inflation figures, interest rates would have been increased to choke off inflation which would have dampened mortgage demand thus reducing the banks’ dependence on traded debt.
Gordon Brown was revelling in the umpteen quarters of interrupted growth that he had presided over as Chancellor. Clearly this was all down to his prudent handling of the British economy had nothing to do with the events in SE Asia at the end of the 1990s. One of the statements that he frequently made was regarding low interest rates; typical mortgage rates having fallen to around 5%. The fact that you needed to borrow twice as much to buy a house meant that your monthly payments were around the same they would have been when mortgage rates were at 10% was ignored, not just by him but by everybody else.
May 2007 came along and Tony Blair went off smiling into a cushy number with the UN working on Middle East peace, a job that you can’t really fail at as it’s unachievable, leaving Gordon holding the baby. vAs soon as he took over the reins it all went very wrong; the wettest summer on record followed by the debacle that marked the end of Northern Rock and the start of the Credit Crunch.
Gordon had appointed the comedic ally named Alastair Darling to pick up the job of keeping the economy ticking over, ‘shouldn’t be hard really it’s gone OK over the last 10 years, just keep fiddling with the tax rates which just move the burden around a bit and you should be OK’. The Northern Rock problems blew up in his face; panicked savers were shown ashen faced on the news night after night facing the loss of their life savings queuing outside branches like in the scene from Mary Poppins where there is a run on the bank. What was required was strong and decisive action; put a floor under the bank, assure customers that retail deposits would not be forfeit. What we got instead was a week of dithering and statements which were long on words and short on content not unlike his namesake from Blackadder. Eventually, the bank had to be nationalised.
As things have steadily gone from bad to worse since September 2007, we were assured that the problems at Northern Rock were unique to the business model that it was pursuing. All other UK retail banks were well run and well capitalised we were assured. Hmmmm! Not really panned out that way has it? It would seem that all the banks were following the same flawed business model.
It must be said that it was the policies of Crash Gordon that have put the UK into a worse pickle than it needs to be. But, the policies that our Darling Chancellor is now pursuing are full of good intent but are sadly misdirected. Banks have been offered a lifeline by the government. By underwriting a forced massive rights issue by the Lloyds Group and RBS the government have wound up as a majority share holder in RBS and owning almost half of the Lloyds Group. This was all promised in rather too much of a hurry. Would a private business buy into another business without performing a due diligence exercise? Not likely, but Darling promised to underwrite the rights issue over a weekend without so much as a cursory glance at the books. After the event the government were surprised to find out that 80% of the loan book at RBS was abroad, including 3bn pounds owed by one Russian gentleman who is rather loathed to pay it back.
What the British economy needed was a shot in the arm, so in the Autumn statement the Chancellor announced a raft of measures designed to give the economy a boost. Businesses were struggling with demand that had, rather than fading, gradually dropped off a cliff. The best place to inject the cash would have been into business via cuts in corporation taxes, increasing capital allowances to encourage investment etc. As a Labour administration, the government could not be seen to be pandering to business which is where the wealth of the nation really starts. They had to be seen to be giving some to business and more to individual families. Child benefits were increased by a couple of pounds a week, tax allowances were increased, but the major headline was given to a 2.5% cut in VAT. The train of thought behind this was that if a tax rebate cheque were sent out to households (as is generally favoured by the US administration) householders may use it to pay down debt or just bank it. In order to benefit from the VAT cut the British public would have to go out and SPEND !
The first impact of this hurried legislation was that businesses up and down the land would have to adjust pricing, tills, computer systems, maybe stationery all at 6 days notice, so the impact to business was a cost in the first instance. There’s nothing to force a business to reduce prices. They could just as well leave prices at the previous level and pocket the extra by paying the VAT at the reduced level. Also, darling Darling has announced that the VAT reduction will be a temporary measure for 13 months only, the biggest fillip that this is likely to have is a sales rush in December 2009 which is not what he intended!
The cost to the exchequer of the cut in VAT is reported to be in the region of £12bn. Now that could have gone as tax rebate to people on the lower rate of tax who are more likely to spend it than bank it. The problem with the ‘SPEND IT’ plan is that the UK has a very small manufacturing base, so any money spent is likely to have a small impact with the retailer, wholesaler and distributor and a somewhat bigger impact in a land far, far away where the products are made. The £12bn wasted in the VAT cut would have been far better spent on measures to increase spending by businesses. A direct cut in Corporation Tax would just be put onto the bottom line, however increasing capital allowances and allowing business to depreciate capital expenditure in the first year would encourage companies to bring planned capital expenditure forward, perhaps increasing their efficiency and productivity.
The government also put in place a number of measures to encourage banks to lend to small businesses with the government standing as guarantor for 75% of the loan value (known as the enterprise loan guarantee scheme (ELG)). This was not discussed with the banks prior to it being announced to the public. Reports in the media seem to suggest that businesses requesting these types of loans with their business bankers are met with blank looks.
The companies that are most in need of cash are companies that are outside the target audience for these types of loans, think Woolworths and some of the major house-builders who have had, in the case of Woolworths, major cash flow problems, rather than Mrs. Miggins’ pie shop and Bob the builder round the corner. It’s the failure of these major employers that will bring the economy down. Many small businesses are run prudently with cash surpluses to see them through lean times.
The ‘Today’ programme on Radio 4 featured the story of a woman who ran a successful chain of cafes in Scotland. Wanting to expand her chain she found new premises and agreed funding (£50,000) with the Bank of Scotland. After signing the lease, the bank pulled her funding leaving her high and dry. She heard about the ELG and trawled around all the other banks asking for a loan under the conditions of the scheme. The banks had either not heard of the scheme or had not yet implemented a plan to lend under the scheme. This has got to be poor communication on the part of the Government. Banks being banks only make money from their loan book. If somebody is going to stand as guarantor for 75% of a loan to an already well established business then it’s not a decision that takes much time…you’ve 100% of the upside and only 25% of the downside risks. When you are lending money to a purveyor of sausage rolls in Scotland this is not a high risk business model!
So, Crash Gordon got us into this position with his policy of leaving it to the Bank of England and excluding things that have gone up a great deal from the inflation calculation. Darling is flapping around throwing money, OUR money, at the problem indiscriminately. The Bank of England is cutting interest rates every month without waiting to see what last month’s cut has done and the treasury is issuing government debt at an alarming rate… both of which are debasing the UK currency.
Here’s a clue for marvellous Mervyn and the MPC….If cutting interest rates to 1% has not worked, cutting them to zero isn’t going to make any difference. The problem is people and businesses don’t have the confidence, or the appetite, to take any more debt on even if it’s interest free. Once interest rates are at zero, Merv has announced his intention to print more money! Now this is a policy that’s been used before in Germany’s Weimar Republic where this model pushed inflation in 1923 to, and this is not a misprint, 560 billion percent and more recently in Zimbabwe where inflation is currently a more modest 231 million percent.
Maybe Darling and Merv have cooked this up as a ‘cunning plan’ as inflation at those levels would quickly mean the Government debt levels would shrink in real terms very quickly but I wouldn’t count on the international community buying any more UK debt after that.
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