Hamish McRae: Don't worry: when the regulators are fretting, things are returning to normal
Thursday 28 February 2008
When the monetary and banking regulators are worried we should really be scared, right? Er, no, wrong. The time for the rest of us to be concerned was when the regulators were too relaxed, as they were a year or more ago. Now that they running around saying that things are terrible I think we can start to relax a bit. That does not mean the banking crisis is past, for we still have a way to go. It is just the gradual correction process is taking place and that once that passes normal service will be resumed.
There were two examples of alarmist speeches by regulators in the past couple of days. Rachel Lomax, deputy governor of the Bank of England, said central banks were facing the "largest ever peacetime liquidity crisis". That cannot be right.
From a UK perspective the present squeeze on bank liquidity is not as serious as the run on the fringe banks in the 1970s, when the Bank's so-called "lifeboat" was established to supply liquidity to smaller banks and when there was the start of a run on NatWest. Unless the Bank knows something we don't, only one of our fringe banks, Northern Rock, has had to have artificial support, and there has been no suggestion whatsoever of a run on a large clearing bank.
And from a global perspective? Are the US banks in worse shape than they were during the Third World lending crisis or the early 1980s property crash? Remember that Continental Illinois, then America's seventh largest bank, became insolvent in 1984 and had to be rescued by the US authorities. Just about the entire Japanese banking system was technically insolvent after the property crash at the end of the 1980s. Or if you are looking at the national burden of supporting banks, remember that when Sweden had to rescue Nordbanken in the early 1990s the cost came to about 4 per cent of Swedish GDP. True, Continental Illinois and Nordbanken had solvency problems as well as liquidity ones, but I think my point stands, that what has been happening over the past six months is within the broad parameters of what has happened in previous banking crises, and on several measures it is less serious.
The other alarmist speech, plus radio interview on Today, came from Hector Sants, chief executive of the FSA. "I don't think markets are ever going to return to the way they were," he told the BBC. "The idea that at some point they will go back to normal, I think, is a misnomer." The era of cheap borrowing, he added, was over.
That cannot be right either – or rather it is only right if you assume that the past three or four years were normal. By historical standards they were most abnormal for two reasons. The primary cause was abnormally low real interest rates, as you can see from the first graph. This shows real short-term interest rates in the developed countries. That dip of real rates to below 1 per cent for five years was the result of flawed central banking policies. It led to banks making extremely risky loans, and because returns also became so low, to banks searching for ingenious ways to improve their earnings. The second reason for the banking problems, the complex instruments they developed to try to improve returns, were a response to these lax conditions. And the regulators allowed them to do so.
As for the era of cheap borrowing being over, well, the era of 125 per cent mortgages may be over, and about time too. But reputable borrowers still have no difficulty getting money on terms close to money market rates. In the past few weeks I have been told by one global resources group and one UK commercial property buyer that they have been greeted very warmly by their bankers. In fact in one case they were offered much more money than they wanted.
I don't want to absolve the banks from their mistakes; my point is simply that the central banks created the circumstances where they, and the borrowers, were likely to make mistakes, and regulators then failed to curb them. Excessively cheap money was mostly a US, Japanese and European phenomenon – though we should not be too hard on the European Central Bank, which had to try to reconcile the different needs of the countries under its monetary jurisdiction. Rates that were too low for Spain were too high for Germany.
Here in Britain money was not particularly cheap, but it was too freely available. The Bank took the narrow view, as it is required to do legally, that it must target inflation. As some of us pointed out from time to time, broad money was allowed to increase at around 14 per cent a year for several years, far above the growth of the economy. To over-simplify, if the economy grows at 3 per cent and the money supply grows at 14 per cent, you are permitting asset prices to rise at 11 per cent, which is pretty much what happened to our house prices in the early 2000s.
Unfortunately it is not as simple as that, because the link between money supply and inflation is much looser. But you see the point. The Bank did what it legally had to do, which was to target inflation, and latterly a narrow and unsatisfactory measure of it. But it failed to achieve the wider aim of all central banks, which incidentally long predates inflation targeting, of maintaining monetary stability and orderly markets. Arguably the FSA made a parallel error, in that it ensured banks ticked the boxes, but not that they ran a stable and sustainable banking system.
You can see the results in the other two graphs. Both the US and UK had a house price boom that gathered pace after 2001, and there was sudden surge in household debts relative to income after 2001 as well. Back in 2000 things were fairly stable, with UK households actually having lower liabilities than German ones. That was normality. What has happened since is abnormal.
So what happens now? I don't think it is very helpful for officials and bankers to bang on about how unprecedented current conditions are. There have been policy errors and failures of bank management. But there are precedents, and these are in the main more disagreeable than the present outlook. For example, any global economic disruption now is not nearly as dangerous as that caused by inflation in the 1970s. The UK housing situation is not nearly as dire as it was in the early 1990s. Equity markets in the developed world are not as overvalued as they were in 2000; in fact they may be rather undervalued. This global downturn may be more serious than the early 2000s one, but it is hardly likely to be as bad, at least for the UK, as the early 1990s or early 1980s. Even our public finances, which are much weaker than they should be at this stage of the cycle, are not as badly positioned as they were in 1990, and vastly better than in 1979.
I think this year will still see reasonable growth in the UK, though tailing off as the year progresses; 2009 will, I fear, be more difficult. There will be housing problems, though not as serious in the US. And the balance of probability is that there will be more financial disruption: we have not yet had the equivalent of Continental Illinois. So while there is a long slog ahead correcting past mistakes, at least the world of officialdom is on the case – not before time.
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