Osborne’s Oscillations

One of the best accounts of the postwar management of the British economy is Samuel Brittan’s 1969 Steering the Economy. The book’s title conjured up the vision of the Treasury, the bridge of the ship of state, taking orders from the captain, the Chancellor of the Exchequer, and relaying them to the spending departments and the Bank of England somewhere in the lower decks. But to talk of “steering” implied that the ship had one wheel and one rudder, and that at any one time it had a well-defined course. This was often not the case. Fiscal policy was frequently inconsistent with monetary policy, periods of “stop” would be followed by periods of “go”, and so on. 

According to a once-fashionable consensus, the muddles were brought to an end by a regime of inflation targeting introduced in 1992. For 15 years or so the people “in charge of economic policy” gave the impression of knowing what they were doing. That impression may always have been misleading. Anyhow, it has been destroyed in the years of renewed confusion since the onset of the financial crisis in mid-2007. Almost everyone accepts that the banking system is central to understanding the economy’s malaise in the last few years, so that the task of steering the economy is largely that of steering the banking system. But views differ radically about how the banking system should be steered. 

Immediately after the crisis a common diagnosis was that the risk of bank failure had been the cause of macroeconomic trauma. The answer was to ensure that banks could never fail again. Critically, they must in future have much more capital relative to the risks in their balance sheets. This was the core doctrine of the 2011 Vickers Report. The report recommended that Britain’s banks should maintain higher capital ratios than mandated by the Basle III rules, which set the internationally respectable standard. 

George Osborne, the Chancellor, accepted the Vickers Report without demur. But it was unsatisfactory in two main ways. First, nowhere did it give a worthwhile summary of the data on the UK banking system’s profits and capital, to see whether the allegation of large-scale potential failure was correct. Such information can in fact be gleaned from official sources and demonstrates that in the crisis period UK banks’ losses were modest relative to their capital. Contrary to conventional wisdom, the case for large increases in capital:asset ratios had not been made. The heart of the banks’ problems in the years since 2007 has been the fact that they have had difficulty funding their assets. (I am not saying the banks were angels, and I accept that — for example — asset quality at HBOS in mid-2007 was poor.) 

Secondly, and more fundamentally for the future, any move to higher capital:asset ratios was bound to lead to a period of low bank asset growth or even balance-sheet stagnation, and so to negligible increases in the quantity of money and protracted weakness in demand, output and employment. In an article in Standpoint in September 2011 I pointed out the Vickers Report would affect “the pace of the economic recovery and hence the outcome of the next general election”. 

By mid-2012 this assessment already looked more convincing, since the recovery was still feeble. How did Osborne, by his own admission a politician “to his fingertips”, react? Vickers’s sponsor in UK officialdom was Mervyn (now Lord) King, then Governor of the Bank of England. From the start of the crisis King was opposed to any kind of lending by the British state to banks, even though this was the obvious way to meet their funding problems. But Osborne bullied the Bank of England into announcing a new “Funding for Lending” scheme which gave the banks medium-term, low-cost finance from the Bank of England, so that they could lend on to the private sector. Even more far-reaching is the Help to Buy scheme announced by Osborne in the March Budget. Homebuyers are to receive direct financial support from the state (in the shape of a so-called “equity loan”) if they buy a new home. Help to Buy “agents” have been appointed by the government all over the country to explain the scheme and facilitate the process. 

Both the Funding for Lending and the Help to Buy schemes are blatant attempts to encourage banks to lend more and thereby to bypass the Vickers constraints. Sure enough, Conservative political fingertips are tingling as the economy starts to show signs of improvement. Nevertheless, the schemes are distorting and artificial, and cannot be sustainable long-run features of a competitive market economy. They are necessary only because Osborne did not have the gumption to reject the Vickers Report, and to overrule King in 2011. The poor old British economy is still not being steered in a straight line. Instead, its housing market and financial system somehow have to cope with another crazy zigzag, arising from official incompetence. 

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