Monday, 25 May 2009

War of Independence

It was all so simple before the credit crunch. The Bank of England was given independence and tasked with keeping inflation (measured using the consumer price inflation or CPI) at 2%. To do this a monthly monetary policy committee (the MPC) meets for 2 days, surveys the data then votes on what the Bank’s base interest rate should be. As most other British interest rates are derived from this base rate, changing the latter would in turn see the others change.

Flexing the cost of credit in this way would in turn influence overall economic rates of activity e.g. if it was more expensive to borrow money to buy ladders, less people would buy ladders, the ladder industry would cut prices to encourage more sales and as ladders are included in the basket of goods used to measure CPI, CPI would fall.

That was then. A defining feature of the credit crunch has been the connection between base rate and other interest rates breaking down, in particular between base rate and LIBOR (London Inter-Bank Offer Rate), which is what banks charge when they lend money to each other. Base rate went down (and down and down), but LIBOR has remained persistently high because banks had suddenly become scared other banks were going to fail and on that basis stopped lending to each other.

Allova sudden it became awfy expensive for banks to get cash to lend to customers if they could get it at all. The result was credit rationing – less new credit is available than before and what is available became suddenly more expensive. Hence, the collapse in the confidence banks once had in each other eventually drove the economy into recession by hacking back the number of debt funded commercial and private transactions.

The thing is there were warning signs in the run up to the credit crunch. Asset prices e.g. of houses, companies and offices, were all growing like gangbusters in the run up to the crunch because the ready availability of cheap credit made them cheap to buy. Raising interest rates would have slowed this down and the MPC was certainly mindful of what was going on in the housing market judging by comments recorded in its minutes. However, that wasn’t the Bank of England’s job and anyway none of these things are included in the CPI basket of goods.

Hence the argument to set interest rates in relation to house prices as well as CPI. Except this is regarded as unacceptable by the Bank because setting interest rates like that might adversely affect every other part of the economy e.g. raising rates to stop house prices growing too fast could damage manufacturing by increasing its credit costs and the exchange rate, which would make exports less competitive.

Instead, when I attended a presentation on the latest Bank of England inflation report given by a lovely Bank of England Agent the other day he described how the Bank is discussing other methods of restricting lending. Except this raises all sorts of yucky issues.

There’s the specific debate already underway as to what method or methods should be put in place to be sure – should it be a cap on loans to value, the rate of growth in a particular type of lending, counter-cyclical capital provisioning, and so on and so on. But, that’s not the point here. Rather, its what this could mean for the Bank’s independence and remit that’s the issue.

We now know that when the Bank does something different like quantitative easing, barely anyone understands it. Because this might be the wrong thing to do, this strikes me as a bad thing. So there is the clear risk of the Bank acquiring new powers and targets no-one understands as opposed to its existing nice, neat and straightforward remit of setting interest rates to meet an inflation target.

Then there is the bun fight already underway as to who does what, like isn’t this something the Financial Services Authority should do? A problem here is regulatory capture with the FSA successfully giving the impression of being so up the banking sector’s arse it’s not true. I mean its something of an open secret as to how shit a lot of internal bank systems are that have been passed by the FSA and as its chairman said himself when deciding whether someone was a fit and proper person the FSA’s main criteria was whether they were a money launderer and that was it really. So you’ve a regulatory body that’s arguably in bed with the banks and not especially competent wanting to make sure no one else establishes tools for influencing bank lending because that’s its job. This is exactly the kind of situation likely to produce a compromise designed more to save face/appease vested interests than it is prevent another asset bubble.

Finally, there’s government. Government likes it when house prices go up because it generates lots of taxes and makes voters happy. So imagine the scene; an election is due and allova sudden the Bank of England wades in using its new anti-house price bubble blaster. What government is going to tolerate that kinda vote losing behaviour? Some might, but most probably wouldn’t, which raises the real risk of the Bank’s independence being compromised by politicians.

As to why this could be an awfy bad thing, perversely one of the big factors contributing to the credit crunch was the success of economic policy. Yup, thats right, its success. In the 1980s the Thatcherite monetarist experiement was a disaster, later on the EMU experiment and associated destructivly high interest rates use to prop up an over-valued pound prompted the last property crash. So by abdicating responsibility for rate setting government and taking itself out the equation, government generated a high degree of (over)confidence - no government rate setting = no early 90s style property crash ever again! Just a pain the banks chose to blow their own feet off instead. In future though we could see government reassess its role and that of economic policy in favour of more intervention.

So there you are then, right now the Bank of England clearly wants to change its remit and is discussing what new tools this will entail. The risk is they end up with a new remit and tools that -

1) Nobody understands (give or take a few professor's of financial economics)
2) Have been compromised to the point of being not very effective
3) Are awfy, awfy difficult to actually apply regrdless of need due to potentially destructive political interference.

I hope they're being awfy careful about what they wish for.

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