Why the Government’s plans to rescue the economy don’t seem to be working

The Times captures the mood perfectly: “The economy is plunging deeper into recession despite emergency tax cuts and the multibillion-pound bank bailout, the Bank of England said yesterday.”

What it fails to mention is that this is all utterly predictable and indeed inevitable. The reason that “Cutting the base rate to its lowest level in more than 50 years, the Bank said the outlook now was worse than a month ago, with manufacturing and consumer spending in sharp decline” is that cutting the base rate is not going to have much impact.

The base rate is just one driver of credit, and it is not by far the most important. What is more, it does not address the real problems in the economy, which is that the credit expansion of the last decade has fooled entrepreneurs into thinking that investments were viable when in fact they were not. In some cases, whole businesses will now need to be liquidated as reality crashes in on those who had been fooled by artificially-low interest rates.

Reducing interest rates again cannot solve the problem. Just as the first rule when one finds oneself in a hole is to stop digging, so the first rule when one finds oneself facing the inevitable crash following an inflationary spike is to stop inflating. Further interest cuts (as preached by all political parties) are simply attempts to stimulate more credit expansion, which means further inflation. This will lead to more poor decisions by entrepreneurs and more unviable businesses being created, expanded or propped up. That can only lead to an even bigger crisis in the long run.

“The Bank of England pinned much of the blame for the economy’s slide on the borrowing drought that high street banks have inflicted on consumers and businesses alike” according to The Times, but in doing so the Bank misses the point. The borrowing drought is the result of banks making sensible economic decisions in avoiding making the same kind of loans that got us into this mess in the first place.

For let’s be clear about this: the loans that the banks are currently proving reluctant to make are those that they fear may not be repaid; those that, in American parlance, are “sub-prime”. In a market where asset prices are falling, many homeowners are in negative equity and many businesses are destined for bankruptcy, further lending would not only be stupid, it would be irresponsible.

Far from cutting interest rates, the Bank of England should be raising them so as to reduce the demand for credit and increase the desire of savers to provide it. In doing so, it will not only redress the massive imbalance between saving and borrowing that has led the West to borrow trillions of dollars of the (thrifty) Asians as well as creating money through government-backed central banks, but it will also accelerate the reallocation of “factors of production” between unviable and viable industries. As a result, it might just make this a sharp but short recession, instead of another painfully-drawn-out one.

Sub-prime, securitisation and how government caused the financial crisis

The bogeymen-of-the-moment are clearly bankers. Photographs of bankers with their heads – or boxes of their possessions – in their hands are commonplace. The sympathy for the former Lehmans employee does not appear to match that felt for the unemployed docker or miner. Schadenfreude is de rigueur at the moment. And if the banker is the bogeyman, the free markets is the wicked system that is now being exposed for what it is (if only!).

But are our current problems really the fault of capitalists and bankers? There is an altogether different narrative that points the finger in an entirely different direction: the sub-prime and securitisation crises were created by government.

The sub-prime problem begins with the US government's 1977 Community Reinvestment Act (CRA), which allowed the Federal Reserve and other US financial regulators to pressure banks into making loans to less-than-creditworthy borrowers. Far from greed driving bankers to offer 100% loans to unreliable borrowers, this position was forced upon them by government.

Thomas DiLorenzo explains the problem:

When the CRA was created during the Carter administration, the administration also funded with tax dollars numerous ‘community groups’ that have helped the Fed, the Comptroller of the Currency, and other federal regulatory agencies to enforce the act. Under the CRA, if a bank wants to make virtually any change in its business operations — merging, opening up a new branch, getting into a new line of business — it must first prove to regulators that it has made "enough" loans to the government's preferred borrowers. The (partially) tax-funded ‘community groups’ like ACORN (Association of Community Organizations for Reform Now) can file petitions with regulators that stop the bank's activities in their tracks, perhaps defeating them altogether. The banks routinely buy off ACORN and other ‘community groups’ by giving them millions of dollars as well as promising to make even more dubious loans.

Not only is the sub-prime market the result of Federal legislation that forced banks to lend to un-creditworthy borrowers, but the practice of dicing up debts and selling them on in chunks that mixed prime with sub-prime loans was also the creation of a Government body.

In order to try to diversify the risk of these loans, the Federal Home Loan Mortgage Company (‘Freddie Mac’) pioneered the ‘securitization’ of bundles of these high-risk loans so that they could be sold on secondary markets. Such ‘securitization’ exploded during the 1990s as a result of government regulation. As Fed Chairman Ben Bernanke himself stated in a March 30, 2007 speech entitled The Community Reinvestment Act: Its Evolution and New Challenges,

Securitization of affordable housing loans expanded, as did the secondary market for these loans, in part reflecting a 1992 law that required the government-sponsored enterprises, Fannie Mae and Freddie Mac, to devote a large percentage of their activities to meeting affordable housing goals.”

The deregulation of banking in 1994 led to banks to elevate their CRA activities so as to avoid objections by these ‘community groups’ to their business activities. Meanwhile, in 1995 the US Treasury Department created the multibillion-dollar Community Development Financial Institutions to pour taxpayers’ dollars into subsidising sub-prime loans.

Indeed, from 1995 banks were pressurised to make loans “without the benefit of many traditional credit-worthiness criteria, such as the size of the mortgage payment relative to income, savings history, and even income verification! Instead, the Fed told banks that participation in a credit-counseling (sic.) program, many of which are federally funded, could be used as ‘proof’ of a low-income applicant's ability to make his mortgage payments. In other words, federal bank regulators required banks to make bad loans based on nonexistent credit standards.” One cannot help but think that participation in a credit counselling programme suggests that the borrower has had credit trouble in the past and may not be an ideal customer.

Though largely a US based problem analysis has three significant messages for our current situation.

Firstly, the eagerness with which journalists and politicians have blamed bankers is misguided. While there is no doubt that bankers can be and have been greedy, the sub-prime mortgage problem was forced on banks by the US government, while habit of ‘securitising’ debt began with a US government housing agency. This is a problem created by government, not greed.

Secondly, for the above reason, the eagerness with which we look to government to solve the problem is equally misguided. Our faith in more regulation to resolve the current mess is misplaced. To my knowledge HM Government did not force bankers to lend to less reliable borrowers, but the excess of credit in the marketplace as a result of Government’s toleration of inflation in the pursuit of low interest rates meant that banks had to look further down the pecking-order of borrowers to find people to whom to lend. Had money been tighter, there would have been a duel break on the problem as borrowers were more cautious due to facing higher repayments and banks were less eager to accept any borrower due to credit being limited. There might have been fewer 100% mortgages to those with poor credit histories or people who were “self-certificating” (a practice known colloquially as the “Liar’s mortgage”).

Finally, the troubles resulting form the US government’s intervention in housing markets and the deliberate policy of encouraging those on low incomes with poor credit histories to borrow against property casts a cold light upon the Labour government’s proposals to give first time buyers cheap loans, ease the payment of mortgage interest using income support and allow council’s to offer cheap mortgages. This last is particularly pernicious as it opens up the possibility that, in the future, councils will be in the invidious position of having to foreclose on defaulters and repossess their houses (which the defaulter would probably then stay in, now as a tenant of the council!).

Much of the current economic mess has been caused by governments, with the US government to blame for the specific trigger and our own to blame for the underlying mess. Our headlong rush to solve this government-made problem with more regulation risks turning a brief if sharp recession into a long depression. But right now we seem stuck with the mindset that “Something must be done”.

A fantastic metaphor for the economy

Llewellyn H. Rockwell Jr. may be focussing on the US Federal Reserve, but he could just as easily be talking about the UK when he writes

The current economic crisis “stems from… a Fed-driven banking system that turns
credit on and off like a monkey playing with a fire hydrant…”

At last, some good news from Brussels

I have just transferred some money between two bank accounts, without leaving my desk, with just a few clicks of my mouse. It is called eBanking. It is not very exciting; indeed, it seems too prosaic to mention. Certainly, it should go without saying that it cost nothing to make the transfer. Why should it? It is just one computer telling another computer that it has reduced a number by a certain amount, and the other computer can add that amount to a number it stores. There is no marginal cost.

Add one more calculation, however, and a fee is charged. Lets say that the receiving computer has to take the first figure and pass it through a very simple formula before adding the figure to the number it stores. Let us call the first number “pounds” and the second number “Euros” and the formula the “exchange rate”. Since time immemorial banks have been telling us that this, for some reason, costs money. To transfer pounds from London to Scotland is free; to transfer them from London to Calais costs money.

I remember having a stand-up row with a bank clerk in Stockholm about this. Why, I demanded, was there a fee? What cost was I incurring? What was the difference between sending money to another Swedish bank and sending it to an English one (even one that had branches in Stockholm)? She was unable to answer the question, of course.

The answer is that there is no extra expense. It is a money-making ruse. It is not the bank’s fault as such, however: they are merely the beneficiaries of national legislation that has failed to inject competition into the banking industry. This may be about to change.

Yesterday, European finance ministers passed the Payment Services Directive. The aim of this is to create a “Single Payment Area, in which citizens and businesses can make cross-border payments as easily, safely and efficiently as they can within their own countries and subject to identical charges.” This means that one can have one’s salary paid into a foreign bank (handy if you are on a short-term contract), debit and credit card payments will be easier (though I’ve never had much difficulty) and those unnecessary bank charges should begin to disappear.

It will also open up the retain banking market to more competition. This is good for everyone, and particularly good for the British. Everybody benefits from competition, and sometimes it does seem that things are a little cosy on the high street. But actually, the UK has a fairly competitive banking sector. Our European allies may get a bit of a shock when HSBC and the Royal Bank of Scotland open up branches in Paris and Munich. And it will make it even easier to pop to the cash machine for a few Euros without having to pay £1.50 for the privilege.

And things should be a bit calmer in SEB without an irate Englishman hectoring a poor Swedish bank clerk.