David Prosser: There is no turning back the clock on credit controls

Outlook: Whisper it quietly, but the free market does work as an effective control on irresponsible lending
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As confessions go, Sir John Gieve's admission that the Bank of England did not realise just how serious the effects of Britain's "crazy borrowing" would be is hardly revelatory. We are ending the year facing a grim recession, but for three-quarters of 2008 the Bank believed runaway inflation was Britain's major economic problem, so Sir John's comments on BBC's Panorama last night will have surprised no one.

What are much more interesting are the soon-to-retire deputy governor's views on how the Bank might tackle the credit bubbles of the future. Sir John's suggestion is that the Bank needs more powers – "new instruments" to "prevent the financial cycle and the credit cycle getting out of hand".

You can see his point, though the deputy governor's critics might point out that all the powers in the world are no use if the Bank doesn't correctly diagnose the problem in the first place.

Sir John rightly argues that had the Bank sought to rein in consumer lending by raising interest rates sharply in recent years, there would have been a storm of protest from across the economy. And in any case, the Bank uses rates as a mechanism for its very specific mandate to manage inflation, not as a tool for wider policy objectives.

If not interest rates, then, how should the Bank manage the credit cycle? Implicit in Sir John's call for powers that include "something more financial-sector specific" is the idea of controlling the supply of credit more tightly. The brutal way to do that is through legislation and regulation that specifically restricts the freedom of banks to lend as they see fit. A more subtle approach would be a return to some form of the "banking corset" that was in place for much of the Seventies.

The corset enabled the Bank to indirectly control the supply of credit in the economy by varying the amount of capital banks were required to hold. The stricter the rules on capital ratios and reserve asset ratios, the less capital banks had to offer their customers.

Such controls were, of course, swept aside by the Conservative government of the early Eighties. Margaret Thatcher's view on the corset, by the way, was informed as much by her thinking about its efficacy as her belief in economic liberalism. "A corset is there to conceal the underlying bulges, not to deal with them, and, when you take it off, you might see that the bulges are worse," she said.

Still, leaving aside Mrs T's rather witty critique, the debate about credit controls remains a philosophical one. Put simply, the question is who we trust most to police the amount of credit available in the economy – should our lending institutions be free to decide how much credit to extend and to whom, or should the state, via the Bank of England or another agency, take such decisions?

At a moment when the bursting of Britain's credit bubble is threatening the living standards of millions of people, an instinctive reaction to crack down on banks' lending practices is entirely understandable. But we shouldn't forget the enormous benefits the deregulation of credit markets has brought – a huge increase in home ownership, higher living standards and unprecedented competition amongst financial institutions for consumers' business, to name but three.

It's easy to forget how credit rationing and the authoritarian attitudes of banks and building societies once fashioned their treatment of ordinary customers. Just a generation ago, for example, it was not uncommon for lenders to demand to see a prescription for contraception before agreeing to lend to women (on the grounds they might be fibbing about their family-planning intentions and their ability to earn enough to stay on top of mortgage repayments).

Indeed, we are already being given a snapshot of what life might be like in an era of much more tightly controlled credit. One reason why small businesses and mortgage borrowers are struggling to get the credit they need right now is that lenders are already being told to be much more prudent in their capital funding. The corset has not formally been imposed, but you can see the principle in action up and down the country.

Instinctive reactions are not always the right ones. Whisper it quietly, but the free market does work as an effective control on irresponsible lending. The institutions in this country and overseas that have most over-extended themselves are the ones that no longer exist in any recognisable form. The shareholders and executives of Northern Rock and Bradford & Bingley, for example, have been thoroughly punished by the market.

The problem, of course, is that everyone else is also being punished for irresponsible lenders' excesses. This is why banks and financial services companies are regulated in the first place – because their mistakes have such awful consequences – and there will no doubt be a great deal more of this regulation to come.

But tighter supervision of lenders is a different matter to taking the decisions about when and how much to lend out of their hands.

In this respect, Sir John's admission that he didn't see the crunch coming is possibly more interesting than at first we thought. It shows that regulators are no more prescient than those they police – in which case, why give them back the power to control the credit supply?