The last run on a UK bank before Northern Rock was – I am unreliably informed – Overend Gurney in 1866. At any rate, it was before I was born. The nearest parallel that I can remember in my own lifetime was in 1974-75 when the combination of recession and inflation was associated with the secondary banking crisis.
The Bank of England had to bail out NatWest. In 1975, everything went wrong at once: GDP fell by what was measured to be 3 per cent at the time (though the scale of the recession has since been revised down to only 0.6 per cent); inflation peaked at 28 per cent mid year; the pound devalued itself; the stock market collapsed; the Government deficit temporarily reached 10 per cent of GDP (equivalent to £130bn today). Eventually, the Government had to go cap in hand to the IMF for a bail-out.
Most of the current problems are about a third as bad and, crucially, the inflationary problem is less than a fifth as bad. But there are the similarities of a Bank of England more concerned about inflation than recession, banks threatening to go under, the balance of payments and government borrowing at high levels and the risk of a consumer spending slowdown.
The immediate problem of Northern Rock is essentially a failure by the regulatory authorities. With 20-20 hindsight, the regulators should not have allowed it to expand its loan portfolio so rapidly. But that is being clever after the event. At any rate there is a moral obligation on the regulators to ensure that any bank with significant numbers of depositors is either explicitly excluded from any guarantee or is regulated to limit its exposure to risky markets. My suspicion is the relatively unnecessary separation of the FSA from the Bank of England since 1997 has been part of the cause of the problems.
But the roots of the present crisis come from when the US sub-prime crisis caused the London inter-bank market to dry up. The Bank of England was strangely passive in pumping liquidity into the inter-bank market with the inevitable consequence that it had to bail out an individual institution.
The problem was compounded by both the inexperienced Chancellor and the economist Governor behaving like bureaucrats and ignoring the potential public consequences of their actions. They should have ensured a full resolution of the Northern Rock problem immediately before the problems became public knowledge. When knowledge of the problem became clear, they should have ensured that the Northern Rock management (who have looked way out of their depth) offered a loyalty bonus to those keeping their money in – so that those depositors who wanted to cut and run had something other than a one-way bet.
The PR of all concerned has been extraordinarily bad and has exacerbated the crisis of confidence. Listening to the Chancellor on the Today programme yesterday, I was struck by how he had managed to obtain the worst of all worlds – putting himself in the legal situation of having given Northern Rock depositors an effective guarantee without having managed to persuade them to stop withdrawing their cash.
The cost of this botched policy is likely to feed back into the real economy. The Bank of England will have to flood the markets with money even at the risk of exacerbating inflation. Interest rates will have to be cut – my guess is to 4.5 per cent by mid 2008, but this forecast has a wide margin of error.
Consumer spending and the housing market are likely to be very weak for the next six months or so. Mortgage funds will be much less available, so housing transactions will dry up; the consumers who have been withdrawing from Northern Rock to put their money under their mattresses are likely to cut their borrowing (which will be less available in any case).
With growth in financial services (which accounted for a third of total GDP growth in the first half of the year) going negative, GDP growth itself could be low or negative for the third or, more likely, fourth quarters of 2007. House prices will probably fall by about 10 per cent – though this will only take them back to last year's levels and the fall would be unrepresentative since it will be measured on a minority of transactions mostly involving forced sellers.
Provided that the US problems only lead to a contraction and not a recession and that China keeps on growing, my guess is that this crisis will prove temporary and that the economy will bounce forward again by the second half of 2008. Then the world's financial authorities will be able to restore their counter-inflationary policies. But there are a lot of "ifs" and "buts" and "provided thats" about this forecast.
The author is chief executive of CEBR, an independent economics consultancyReuse content