This windfall disaster could have been prevented

`It was within the power of government to have slowed the stampede to a manageable pace by raising the electoral hurdle required for the building societies to go public'
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It was recently described to me, by a senior Treasury official, as one of the greatest disasters to hit the British economy since the war. It could have been stopped by the last government, but was not - for motives that were not necessarily the best. It has, in mitigation, made more ordinary people better off than they probably ever dreamed - but unfortunately at totally the wrong time in the business cycle. It is the greatest headache facing monetary and fiscal policy in the UK today.

I refer, of course, to the pounds 37bn windfall gain which consumers are enjoying this year as a result of the transformation of many building societies from mutual societies into public companies, quoted on the Stock Exchange. This sum is equivalent to almost 5 per cent of UK national income this year, and 7 per cent of consumers' expenditure. It is a potential disaster because it injects into the system a massive dose of new spending power just at a time when consumers' confidence was already surging, and when retail sales were already rising at an unsustainable rate of 5-6 per cent per annum.

Because the financial markets have assumed that the Bank of England will respond to this spending spree by raising interest rates, the exchange rate has risen sharply, and is now about 18 per cent overvalued, according to calculations by Goldman Sachs. This rise in sterling is temporarily suppressing inflation tendencies, but will eventually lead to balance of payments problems and then to a decline in industrial production. Ironically, we seem to be facing a repeat of the problems of the late 1980s, when another phenomenon relating to building societies - the abolition of restrictions on their lending behaviour - helped to blow the lid off the economy, thus causing the recession of 1990-91.

Given the risks that this involves, it is worth asking how it ever was allowed to happen. Under the Building Societies Act of 1986, the humble thrift institutions which had rendered such valuable service over a century or more to small investors and housebuyers were allowed to transform themselves into public companies, provided that they could obtain the consent of 75 per cent of their members (not just those who voted in any ballot, but all members) to make the change. The idea was to provide a level playing field for competition within the financial services industry, hopefully leading to better service for customers in the long term. A very laudable micro-economic objective - but one fraught with very great macro-economic risks, if the process of change should happen too precipitously.

During 1994/95, it became apparent that change would happen very precipitously indeed. The takeover of Cheltenham & Gloucester by Lloyds Bank was swiftly approved by the owners of the mutual society, and the Treasury (knowing that financial markets can be creatures of mass psychology) became acutely aware that sweeping changes to our most important savings institutions could soon be afoot. Several legal judgments had just clarified the voting requirements which the societies needed to fulfil before they could go public, and these judgments greatly reduced the electoral hurdle that had to be crossed.

Essentially, it became possible for new members to vote in the decision to go public, even if they did not qualify under the previous rule which required membership for two years before enfranchisement. This meant that "carpetbaggers", who were switching around their building society accounts simply in the hope of making instant windfall gains, could vote in the process, making a 75 per cent "yes" vote far more likely than before.

It was at this point that ministers could have stepped in to slow the process. Apparently, they were asked to do so by Treasury officials, who claim to have spotted the macro-economic dangers by this time. The best way of throwing sand into the wheels would have been to have insisted that the old two-year voting rule should continue to apply, though it may have required legislation to accomplish this. Perhaps something more forceful would have been required - say an extension of the voting rule to five years of membership - but it was within the power of government to have slowed the stampede to a manageable pace by raising the electoral hurdle required for the societies to go public.

Treasury officials say that ministers justified their decision to allow the stampede to go ahead in the name of increasing competition in the financial sector, but that they really took the decision with one eye on boosting the feelgood factor around election time. If the government had done this by making equivalent cuts in consumer taxation, it would have been drummed out of office for crass electoral "bribery", but no one seemed to notice the impact of these arcane changes in the voting procedures of mutual societies.

Worse still, many economists denied that the impact would be very big. At a meeting of Ken Clarke's "wise persons" with the last Chancellor in 1996, I was astonished to be the only one of the panel who argued that the windfalls could have large and damaging effects on consumer spending. The others argued that increases in wealth of this type were not likely to boost spending, because the owners of the building societies should already have made allowance for this notional wealth in their personal balance sheets.

Alternatively, the wise persons believed, consumers should have realised that in the long term they would be made worse off by the fact that lending rates would be higher, and deposit rates lower, as the transformed building societies sought to raise their lending margins to earn a higher return for their shareholders as public companies.

I am afraid that this struck me at the time as an example of how the best economists in the country can sometimes lose touch with common sense. I still have the same feeling. Of course it is possible to claim that pounds 37bn of extra wealth is relatively small beer. It compares, for example, with a rise of pounds 80bn in the value of the housing stock, and a rise of pounds 271bn in the value of personal sector holdings in the stock market, in the past year. In comparison with these changes, the building society bombshell does not look very large, but the difference is that the latter is particularly visible to households - they receive letters telling them that they are suddenly several thousand pounds better off - and they extend to people who have no other form of assets, and who are therefore more likely to spend the gains.

Admittedly, it is still too early to assess the full extent of the damage which has been done by this manoeuvre. But recent evidence is that the size of the windfall will be almost twice the pounds 20bn expected at the start of the year, and that up to 25 per cent of the gains might leak into consumer spending, instead of the roughly 10 per cent assumed earlier. If these figures are right, they will be hard even for the most sceptical macro- economist to ignore. And as the economy struggles to negotiate the ensuing boom, we should not overlook the source of the problem - electioneering, though of a very subtle kind.