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12 March 2009 | Paul Gostick Blog
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A New Chapter in Banking History
This week Paul looks at how the banks that put us into this ressession now need to become part of the solution to get us out of it..

Economics is about supply and demand – production, distribution and consumption and, in the main, concerns combinations of price and quantity. Conventional monetary policy focuses on changing the interest rate, i.e. the price, at which the central bank will supply money to the system. The fact is that the central bank can vary the price and quantity of money to control the economy – easing if you like.

In my blog of 14 January, I suggested that we were marching into uncharted waters and facing the prospect of ‘quantitative easing’. Quantitative easing describes the monetary options available to a central bank when conventional monetary policy has run out of steam – bank speak for printing money. In January, the Government was adamant that we were not even in recession let alone depression so any talk of printing money was premature. At the time I asked the following question - “can we trust Gordon and his merry crew to print money and provide the right level of financial stimulus without wrecking the economy for good?” Well, two months later quantitative easing is with us and the jury is out!

We are in a mess. A mess caused by the banks and the excessive credit culture. The current problems are exacerbated by the banks who, despite being ‘given’ billions of pounds of taxpayers money to cover the ‘toxic assets’ they created, refuse to lend and worse their senior executives are paid obscene amounts of money for failure. The government claims that it will not reward failure but Sir Fred Goodwin is reported to be getting a £700K per year pension from age 50 for wrecking Royal Bank of Scotland (RBS) and Eric Daniels is paid handsomely (£960K per year salary plus bonuses) and will get a large pension for virtually destroying one of the previously great banks – Lloyds, with his ill-judged acquisition of HBOS.

Banking greed caused this problem, banks have taken state handouts to mitigate their own business failings, but their refusal to lend will exacerbate and prolong the recession for us all. Only this week, an engineering company, Wrekin Construction Group with an order book worth millions of pounds has been forced into administration. Why? Because of RBS’s apparent inflexibility in releasing funds to ease its temporary cash flow problems. This is a state owned bank and the tax payer will now have to fund the redundancy payments, unemployment benefits for 500+ people and the existing overdraft will be frozen by the administrators and is unlikely to be repaid.

The banks are the problem. They need to become part of the solution. Banks must start lending to businesses at sensible rates. As I write, I believe it is the case that no business has successfully taken advantage of the new government underwritten business loans scheme.

Interest rates affect both savers and borrowers. It is widely assumed that macroeconomic theory drives the reductions in interest rates. Put simply, lower interest rates lead to more credit, which in turn leads to more economic activity. However, at the current interest rate levels this has been proven not to be the case. In another attempt to stimulate the economy, the Bank of England has halved interest rates to 0.5 per cent another record low. Reducing the minimum lending rate from 1.0 per cent to 0.5 per cent will have little or no effect on the end users of credit, or the economy.

However, on a purely practical note, you can’t reduce interest rates any lower than 0 per cent. Once reached, price-focused easing can go no further and a new approach is required. The central bank can still vary the quantity of money it supplies to the system – hence the expression ‘quantitative easing’. In practice, this policy means that the Bank of England will buy assets in the markets. Central bank money is the base of the whole monetary system. Thus, it can pay for these assets by simply creating deposits with itself, expanding the size of its balance sheet.

Quantitative easing has arrived and for the first time in its 315 year history, the Bank of England is printing money to use as its primary vehicle to control the economy. As someone put it to me, it is rather like giving children more sweets that they could possibly ever eat to teach them to share. The Bank of England has taken a giant step into the unknown by giving an undertaking to create up to £150 billion of cash to pour into the UK's struggling financial system.

It will pump £75 billion into the economy in the next 3 months, claiming that this is the only way to prevent the UK from a lengthy recession and potentially entering a period of deflation.

The Bank of England knows reducing interest rates will not work. What they are really trying to do is make it easier for the banks to borrow money and to enhance their margins when they lend. It is designed to facilitate the recovery of the banks’ balance sheets, despite the disastrous effect on savers. Certainly such paltry rates will discourage saving, but why should the banks care when they can borrow easily because of the £75 billion of ‘quantitative easing’ available in the system?

We are in uncharted waters with little evidence that quantitative easing has succeeded in practical terms elsewhere in the world. Low interest rates and printing money fuel inflation and undermine the strength of the pound and can lead to devaluation. In effect, penalising prudent savers. The UK is now effectively in a state of high inflation. Of course, the politicians will tell us that inflation is low because the indices they use are conveniently skewed by sharp falls in both oil and house prices. We need to look beyond the rhetoric. As the average consumer doing a weekly shop will attest, it is plain to see that underlying inflation is rising.

Quantitative easing is not some magic silver bullet that will solve all our financial woes. In fact, the consequences of quantitative easing could create uncontrollable inflation several years from now. Worryingly, the Bank of England says that there is no limit to how far it could go down this untried route. I only hope that those (currently) in charge know when to take their foot off the accelerator.

The real key to recovery is getting the banks lending (responsibly) again and sustaining it. This will take more than merely drowning the system in printed money. It will require confidence and trust to return and that will take time.

Sadly, all this will have to be paid for and, you guessed it, as the tax payer we are in for years of eye-wateringly high taxes.

Being in such uncharted waters reminds me of the old saying – in the land of the blind, the one eyed man is king (no puns intended)! 

Any feedback and comments are always welcome!! 

Paul Gostick Email to a colleague | Add to MY ITP

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