The Governor of the Bank of England, Mervyn King, and the Chancellor of the Exchequer, Alistair Darling, seem to agree on one thing at least. They both think the economic contraction is slowing and that activity will rebound, possibly quite sharply, towards the end of this year, early next year.
But on what happens after the bounce there seems to be little unity of view. In presenting the Bank of England's quarterly Inflation Report yesterday, Mr King gave a number of reasons for thinking that a return to decent levels of sustainable growth may take a good deal longer this time around than previous post-war recessions.
The difference matters because the Chancellor's forecasts for the public finances are based on the resumption of above-trend growth to 3.25 per cent per annum from 2011 onwards. If this doesn't happen, then the Government's books are going to be in even worse shape than they are already. The fiscal consolidation would have to be that much more painful, and the amount borrowed to bridge the difference between spending and tax receipts even larger.
Not that the Governor wanted in any way to criticise the Government's forecasts. Absolutely not. Here was a God-given chance to dump on a self evidently dying Government, but whatever his true views about the fiscal position, the Governor was determined to resist it. In fact, he leant over backwards to be kind. He congratulated the Treasury on its "honesty" in owning up to the scale of the fiscal challenge and even went so far as to say that the deficit may not in the end be as bad as forecast in the Budget red book.
Nor, on examination, does the Bank of England's own central projection for growth look significantly different from that of the Treasury. On this measure, the Bank of England thinks the recession may be a little deeper than the Chancellor assumes and the level of sustainable growth after the recovery a little bit lower, but the broad trajectory is much the same. So how to reconcile these relatively optimistic projections with the Governor's more downbeat comments on the outlook for growth?
One answer that Mr King likes to give when referring to all his forecasts is that the Bank's central projection is only that – a central projection which is no more likely to be true than more outlying projections, one of which has the UK economy still contracting at an annual rate of 1 per cent even as far out as two years hence. Taking all the projections together, the weight of risk is charted to be very much on the downside. In other words, the outcome is more likely to be below the central projection than above it.
This might sound a bit like hedging your bets, and in some respects it is. Mr King is the first to admit that he cannot know the future. None the less, policy has to be set according to the balance of probability if it is not to end up stumbling around in the darkness of guesswork, and the Governor's more gloomy prognosis certainly seems more plausible than the Government's.
Mr King gave three reasons for believing growth would rebound in the short run. First, the degree of monetary and fiscal stimulus has been without precedent. A further boost has been provided by the depreciation of sterling and the drop in the oil price. Third, the inventory adjustment which has dragged down output should soon turn and work in the opposite direction.
But there are equally compelling reasons for supposing that a sustained recovery will take considerably longer than past recessions. Necessary fiscal consolidation might dampen the pace of recovery in household and corporate spending. Households also need to repair their own balance sheets and the savings ratio has to be allowed to recover. What's more, it is likely that the supply of credit will remain restricted as risk averse banks continue to deleverage and raise their capital ratios.
Is the Governor right to be downbeat? There were lots of contradictory messages in yesterday's presentation. In part these result from the Governor's slightly self-justifying analysis of the causes of the crisis and his refusal to admit that there were mistakes in monetary policy. It wasn't inflation targeting or the manner in which it was pursued that was at fault, the Governor insists, but rather that policymakers didn't have the tools with which to address the credit bubble.
Two-thirds of the growth in credit, he says, was nothing to do with excessive consumer spending, mortgage lending, or business investment, but was within the financial system itself, a giant ponzi scheme if you like of one layer of credit derivative on top of another.
That may be true, but it is also the case that much of this credit derivative and shadow banking activity was specifically designed to drive credit growth in the real economy. It certainly succeeded. In Britain, the self-certified and buy-to-let parts of the mortgage market didn't really exist 10 years ago. By the end they were at least 20 per cent of a mortgage market whose traditional elements had also grown substantially with the rise in house prices.
There was also dramatic growth in credit card lending and other forms of unsecured or poorly secured lending. Much of today's bad debt experience has little to do with credit derivatives, but rather is driven by individuals and businesses who were simply allowed to take on too much debt.
That said, the overhang of credit derivatives was indeed one of the main reasons why credit to the real economy first became restricted. Banks with exotic assets of unknown value are bound to worry about how much capital they have available for ordinary lending. So when confidence in these instruments collapsed, there was a knock on effect. But today, the bad debt experience is a much more conventional one. The Bank of England cannot altogether escape blame for an unsustainable boom in credit.
In any case, the Governor seems to acknowledge that whether it was the fault of loose monetary policy or not, households did indeed overborrow and that the necessary process of rebuilding household balance sheets will crimp growth into the future. According to Mr King, there is an equally daunting task of balance sheet repair still to come in the banking sector, not withstanding the recapitalisations that have already taken place.
Recapitalisations to date may have stabilised the banking system, but they are not enough to return lending growth to former levels. The Governor says there is no scientific way of knowing what these capital requirements might be, as a bank's propensity to lend is dictated by market confidence and appetite for risk, but they might be big.
Regrettably, it won't be market sentiment that determines these things in future, but regulatory diktat. Here's another reason for believing that future growth might be subdued. In attempting to make the banking system "safe", regulators may permanently damage its propensity to lend by insisting on bigger capital buffers than strictly necessary.
Policymakers want both growth and safety, but they may be just trading one for the other. The level of banking capital needed to restore past levels of lending growth may be "unknowable", but most policy markets already think they have a fair idea and, like Mr King, want to make it "big". Other mechanisms for supplying risk capital will eventually be found, but the evolution of such conduits is bound to take time.
So lots of mixed messages in the Governor's presentation yesterday, and necessarily so, for we live in uncertain times. The economy will eventually heal, Mr King observes, but the process may be slow. Quite so.Reuse content