Jeremy Warner's Outlook: Darling wants a better early warning system – now where have we heard that before?

Darling's optimism on UK housing
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The Independent Online

For long-standing observers of the capital markets, the present chorus of calls from lawmakers for an early warning system to identify the potential crises of the future is wearily familiar – as indeed are similarly framed demands for root-and-branch reform of the "global financial architecture".

Exactly the same cry went up after the emerging market crises of the late 1990s, as it has done down the ages with virtually every banking and financial meltdown of any significance.

Yet little of any real consequence ever comes of all this soul-searching. Regulation is reformed, worthy international organisations are convened, millions of dollars of taxpayers' money is spent flying delegates around the world business class, and then, come the next boom, all their work, worthless or otherwise, gets thrown in the bin.

So it is with the Financial Stability Forum, the organisation set up in 1999 to promote international financial stability "through information exchange and international co-operation in financial supervision and surveillance".

According to the FSF's website, the organisation's purpose is to co-ordinate the efforts of international regulators and supervisors "in order to promote financial stability, improve the functioning of markets and reduce systemic risk".

A fat lot of good it has proved, too. Where was the FSF to warn of the consequences of the debt build-up of recent years, and where was the FSF to head off what has recently been described by the International Monetary Fund as the worst financial crisis since the Great Depression? If it warned at all, it was plainly completely ineffective.

Yet now the FSF is again identified by the British Government and others as a possible template for the early warning systems of the future. Its report and recommendations are to be used as the basis for discussion at this weekend's meeting of G7 finance ministers in Washington.

Apologists claim that the reason the FSF hasn't worked to date is largely because of American obstruction. The US never really bought into the idea, in part because it believes that made-in-America regulation is the only one worth having, but also because it doesn't really believe in attempting to pre-empt developments in financial markets in the first place.

There is quite a pedigree of this way of thinking in the US, and rightly so in some respects. The causes of financial crises are generally self-evident after the event, but far from easy to identify in the period leading up to the crisis and almost impossible to do anything about even for those blessed with perfect vision of the future. You try stalling a boom in full flight. Any government or regulator that tried to do so would be hung, drawn and quartered.

None the less, the financial system has been so profoundly shaken by the sub-prime meltdown that usually reluctant US policy-makers may in future prove more open to persuasion. The crisis has already required massive government intervention, with repeated infusions of central bank liquidity and the overt use of taxpayers' money to provide a number of rescues on both sides of the Atlantic.

The quid pro quo for these bailouts is that financial markets will have to accept a higher degree of supervision and regulatory interference. Bankers cannot expect to be bailed out and then carry on as before as if nothing has happened. They will be made to pay for their excesses.

Regular readers will know my views on these matters. All regulatory reform is inevitably about fighting the last war, about plugging loopholes and weaknesses exposed by the crisis that's just past, rather than focusing on the road ahead.

Most financial crises have common themes, but they tend to take radically different forms and are by definition largely unanticipated until it is too late. Whatever regulators do, markets will always stay one step ahead. As each door is closed, financial innovation inevitably finds others to open.

For instance, the more effective capital adequacy regulation introduced by Basel II only encouraged bankers to seek ways of conducting growing quantities of business off balance sheet, regardless of the sometimes extreme liquidity risks they were running by so doing.

From greed-fuelled investment bankers to incompetent credit rating agencies, there are a myriad of different people and organisations to blame for the present mess. Yet I doubt very much that the present orgy of regulatory and supervisory reform will do much to prevent the next crisis, which will probably come from China, India or some such other economic boom beyond the control of the newly beefed-up FSF.

The root cause of the present debacle lies, in any case, not in the minutiae of financial markets, but in the flood of liquidity that came pouring out of the boom economies of Asia and the Middle East and the failure of macro-economic policy makers here in the West to control it. Monetary policy both in the US and the UK was kept too loose to prevent this explosion of liquidity from feeding a self-sustaining bubble in the housing market, which in turn created yet more demand for credit.

The looseness of policy found its most extreme manifestation in the US, but it was in some respects equally bad in the UK, where the Bank of England has been obliged to pursue a narrowly defined inflation target that now looks inappropriate to the magnitude of the challenge.

It is not just that the inflation measure used takes no account of asset price inflation such as housing. Rather more seriously, the inflation target also failed to reflect the powerfully disinflationary effect on prices of rapid Asian industrialisation.

This caused price inflation in the UK and elsewhere to be lower than otherwise. With the excess in liquidity unable to find its way in the normal way into goods price inflation, it went instead into assets. The solution is not, as so frequently argued, to rein in the bankers and further neuter the Bank of England, but to free the Monetary Policy Committee from the straitjacket of the inflation target so that it has the flexibility to pursue an interest rate policy that is fully appropriate to the constantly shifting sands of economic conditions and financial markets.

Darling's optimism on UK housing

It was brave of the Chancellor in a speech in Washington yesterday to claim that "the UK housing market is unlikely to experience problems in the way that the property market in the US has been affected".

He cited three reasons in support of this contention. One was that the US meltdown is partly driven by a large overhang of unsold houses, while, in the UK, housing supply had not kept pace with demand. In point of fact, there is evidence of just such oversupply, at least at present prices, with growing numbers of new-build flats failing to shift.

Substantial growth in the buy-to-let market also creates a glut of properties that can easily be sold to take advantage of the present high level of prices if investors started to believe they might fall.

Mr Darling claims the UK has a much smaller sub-prime sector than in the US. Up to a point this might be true, but nor is the sector insignificant. Meanwhile, US experience demonstrates that sub-prime woes rapidly spill over into what were previously regarded as less risky areas of the market.

Finally, Mr Darling claims that UK mortgage lending is subject to much stricter controls than in the US. Really? What's the evidence for this? The IMF reckons UK house prices will fall 10 per cent this year, and are 30 per cent overvalued, implying further falls in the following two years. The present mortgage famine makes this a rather more believable prognosis than that of Mr Darling.

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