As 2011 begins, the most significant risk for the economy remains the banking sector. Incredibly, despite the banking crisis now having gone on for more than three and a half years, there are still no adequate mechanisms in place to properly resolve a failing bank, imposing losses on bondholders and (if push comes to shove) depositors. The complacency and extraordinary Sunday-afternoon-stroll pace concerning this issue reflects three key facts:
- Despite the Irish, Greek, and other crises, many governments appear to believe that they have dealt with the banking crisis by taking the debts onto their own balance sheets, so that reforms to the financial sector are all a matter of “the next crisis” in ten years’ time or so, so there is no particular hurry.
- Many leftist politicians are seeking to take the opportunity of the crisis to impose all kinds of long-desired wish-list constraints on the financial sector and on the activities of the wealthy in general.
- What the experts insist must happen – in particular, mechanisms for imposing losses on bondholders in special administration regimes – is precisely what opponents of the 2008/9 bailouts insisted should happen at that time, but if that is indeed the way the regulatory changes go, the obvious question to ask will be: why didn’t you do that in 2008/9? Why did you prefer a strategy that created the worst recession in the UK since the 1920s (much worse than the 1930s) and that bankrupted several countries, leading to civil unrest?
At the same time, two and a half years after the foolish decisions of late 2008, governments are still throwing hundreds of billions more at the banking crisis. Of course, by now it has become politically unpalatable to be too overt about it – indeed, in many countries it is doubtful whether the public would tolerate further explicit banking sector bailouts. So instead of doing it explicitly, we use the thinly veiled subterfuge of bailouts for countries. Why was Ireland bailed out? Because otherwise it would have imposed losses on senior bondholders in its banks, the strategy of “no creditor must lose” would start to unwind, some of the creditors that would lose would be state-owned banks in the UK, Germany and France, and the governments of those countries would be forced to consider whether to finally embrace reform or instead to provide yet further equity injections into their banks.
To avoid that, they were willing to shove another hundred billion-odd at the Irish. The bailouts of Ireland and Greece are simply a continuation of the banking crisis in another form.
But at any moment the strategy might simply prove impossible to sustain. Could Spain finally be the point of surrender? If so, that could precipitate another round of explicit banking sector collapse. If the British government does not wish to have its own sovereign creditworthiness broken, then this time it must demonstrate a willingness to impose losses on bondholders (and, if push comes to shove, depositors) in banks. To do that, it must establish credible administration regimes. The clock is ticking.
That’s not the only way it’s ticking. When, last August, I repeated my contention from February 2009 that on exit from the financial crisis, we would do well to keep inflation down to 10% RPI/6% CPI at peak, and that if even that were to be achieved, households would need to be repairing their balance sheets much faster than the data up to then indicated, there was more than a little scepticism. Now, with CPI expected to reach 4% by the spring and the risk of further acceleration later in the year if growth exceeds expectations (which I believe it will, despite a significant slowdown or even contraction in the first three months of 2011), concerns about inflation are suddenly all the rage.
Yet the policy dilemma is extraordinarily difficult. The Bank of England missed the opportunity it should have taken in early November to join the international second phase of quantitative easing (QE). Perhaps it will try again in February, if the data allow it. One route would be to combine additional QE with modest interest rate rises, taking rates to around 1.5-2%. Recent surveys indicate that much more than 2% rises in mortgage rates would leave around three million households in financial distress, so the consumer is a long way from yet being able to tolerate interest rates high enough to prevent inflation from accelerating. Household budgets are being squeezed by tax rises (particularly VAT from January) and price inflation that is higher than wage inflation (real wages are falling).
Of course, if banks were to go under (and perhaps the British sovereign with them) then we would immediately be talking about deflation again. (All kinds of things could be the trigger – euro breakup, China, the US, a nuclear war in the far east, a revolution in Southern Europe.) And deflation would impose further burdens on household budgets, as nominal wages might fall and the burden of mortgage debts rise. That’s perhaps a 15% risk – serious enough to worry about; in my view serious enough to act against (through more QE). But it isn’t the central case.
More likely is that by the middle of next year we are into an investment boom in the UK, as slowdown or one-quarter contraction does not turn into more serious crisis, and companies that are currently sitting on large cash piles and that have foregone extensive investment opportunities during the recession (falling investment was a major driver of the contraction) will finally start to use their money, putting it into real assets ahead of the inflation to come.
This year – 2011 – is more likely to be the transition than the blow-out. If we don’t get into serious deflation by the end of the year, and our banks haven’t collapsed and our government has stuck to its task on the deficit, then (especially if we can get credible administration regimes in place for the banking sector) we will be well onto the exit path from these events, with just the inflationary splurge to clean up.
Deficits, spending cuts, taxes, and “plan B”
The key issue regarding sovereign creditworthiness for the UK is (as it was for Ireland) the banks, not the deficit. If there are not to be proper private sector mechanisms for imposing losses on bank bondholders – if the government is to be responsible for the foolish loans made to the banks – then the answer is nominal growth. Some of that will involve inflation (incidentally, imposing larger losses on depositors than anything plausible they could have suffered if the banks had gone under, even disorderly banking failures); and some will be real growth. The most straightforward tool the government has to deliver higher real growth over the medium term is to reduce public spending – as it is doing.
Tax rises, by contrast, were mainly a political device. They were required in order to secure political acceptance for the spending cuts, to create the sense that “we are all in this together”. The best tax rises for that purpose would have been in the basic rate of income tax – nothing is more collegiate than that. Furthermore, basic rate income tax rises are less distortionary to economic activity than VAT rises (partly because VAT applies at full rate to only about 55% of goods and services, so rises in VAT distort activity away from VAT-ed products to non-VAT-ed ones), and so VAT damages longer term growth by more than basic rate income tax.
(There is a great deal of confusion about this point, partly caused by misleading OECD studies on “direct” versus “indirect” taxes, showing that “direct” taxes damage growth more. But the “direct” taxes in question include taxes known to be highly growth-damaging, such as social security contributions (e.g. employers national insurance), whilst the “indirect” taxes include near-universal taxes such as New Zealand’s GST (which applies to virtually everything) and hence are very different taxes from VAT (which applies to only just over half of goods and services). For more on the growth damage caused by VAT see here.)
The government’s key problem in this area is that it has refused to state that it wants to reduce spending, that spending was too high as a proportion of the economy. Instead, it has insisted that it does not want to cut spending, but is forced to do so by the deficit. But if everything it is doing is a “necessity”, there is no room for manoeuvre. Now, regarding spending cuts there really isn’t any such room. Even the cuts there are planned are the minimum really required, in the circumstances, to deliver the longer-term growth we need to pay off our debts. Backtracking on any spending cuts would be disastrous.
But the government really should not have felt the need to box itself in so far regarding tax. Changing taxes in particular years to reflect economic circumstances is a perfectly normal and legitimate part of policymaking. In late 2008 I recommended a temporary income tax rebate to try to provide a temporary boost to counter the recession (and I opposed the spending rises). As it happens, the Labour government went for a temporary VAT cut, opposed by the Conservatives. I think an income tax rebate would have worked better than the VAT cut, but studies suggest that the VAT cut had a definite effect (comments from some politicians about the VAT cut money being thrown away were, frankly, silly and ignorant – no tax cut is ever “thrown away”, because the money doesn’t disappear and can always be taxed back later if necessary).
If we need a plan B next year – say, if credible bank administration mechanisms were to be introduced early, so that a bank collapse wouldn’t bankrupt the government, and then a bank did indeed collapse, creating deflation – the place to find the flexibility is in taxes, particularly income tax, VAT, and corporation tax. I don’t expect we will need any such plan B, and I don’t see why the government needs to spell anything out, but a general willingness to be more flexible on taxes than on spending cuts would be a desirable “atmospheric” change for the government to adopt as a new year’s resolution.