Wednesday, 8 October 2008

Another panic rate cut

The world's leading central banks decided to sing in chorus, and it is the same old song. They were cutting rates by 0.5 percent, hoping to dazzle the rest of us by their boldness and resolve.

Here in the UK, real interest rates are now negative. Inflation is running 4.7 percent while Bank of England policy rates are now 4.5 percent. That kind of monetary policy isn't normally associated with thriving economies.

What??? I dare to mention inflation while global financial markets are crumbling to dust? Well, I suppose someone has to bring up the unpleasant reality that prices have shown no inclination to fall, despite the credit crunch.

All week, I have been reading articles exhorting us to forget about inflation and focus on the financial crisis. OK, let's go with that and forget rising prices for a while. Instead, lets focus on the question whether the rate cuts will actually solve the crisis before us.

There are two simultaneous and connected meltdowns going on right now. First, world equity prices are crashing. Stock markets are pricing in a massive global slowdown.

Now, in normal circumstances, a 50 basis point cut in the face of slowdown would have turned stock markets around. Not today, it seems. Stock markets don't believe that banks will actually deliver the higher credit growth associated with lower interest rates. In the credit-dependent economies of modern capitalism, this relationship has broken down.

This is, of course, the second crisis. The balance sheets of many banks are in very poor shape. Up until a few weeks ago, the worlds central banks treated this problem as one of liquidity. They believe that if they pump in huge amounts of money, then the problem would go away.

Today, in the UK at least, the authorities are beginning to understand what needs to be done. Banks need more capital. Unfortunately, as expected, the BoE, the treasury and the FSA produced a muddle. Under today's plan, the government will buy non-voting preference shares, which will help reduce the pressure on banks, at least until those housing related losses start to pile up. Over the long term, today's capital injection is likely to the the first of many. This thing isn't going to stop at fifty billion quid.

What was needed was something altogether more radical - full nationalization of failed banks, followed by a comprehenive recapitalization and privatization in the distant and hopefully calmer future.. It needed to be done ruthlessly and rapidly, sending a clear signal that failed banks come under government control, and successful ones will remain. We will get there in the end, but I just wish that we got there quicker.


Mark Wadsworth said...

full nationalization of failed banks, followed by a comprehenive recapitalization and privatization

Agreed. As the recapitalisation is a debt-for-equity swap, i.e. bondholders get given new bonds with a face value of (say) 70 pence for every £1 they held, plus 30p face value of new shares.

Faced with the credible threat that the gummint would do this, management, shareholders and bondholders would waste no time in thrashing out the terms.

As to the 'massive mortgage related losses', even worst case, with a 42% price drop in the UK, using BoE figures, the losses suffered by banks would be around £40 billion, which is roughly 3% of UK bank lending to UK households. Big deal, frankly.

Mark Wadsworth said...
This comment has been removed by the author.
Mark Wadsworth said...

Oops. I mean to start that second paragraph

"Agreed. As long as the recapitalisation ..."

Anonymous said...

Conservatives' Ken Clarke on last nights' Newsnight was against a rate cut; saying what we all know - it won't make any difference and will stoke inflation pressures later. Didn't stop LibDem spokesman (can't remember his name, doesn't matter) from playing his same (and only) tune of calling for a rate cut.

Anonymous said...

On inflation, something that is worth noting...

Sterling took a far smaller proportional drop in its interest rates than did the Fed or ECB. This means that the effect of the coordinated action will be to strengthen Sterling against every currency that matters (except the Yen) so inflation in everything non-yen denominated should ease as a result.

Of course, there are other effects... the interpretation by the markets of Treasury intervention in our banks might weaken our currency - as might realisation of the extent of privately held debt... so, my analysis here is "all other things being equal."

Nick von Mises said...


The rate cut is all about steepening the yield curve for a stealth recapitalisation of banks, and also to make the inevitable drop in interest rates from flooding the system with money appear to be a desired rather than predetermined consequence of doing so.

Nothing at all about inflation or preventing global recession. They've given up on that.


Anonymous said...

Just wait, we are going to get it all; bank failures, recession and inflation.

Anonymous said...

Just wait, we are going to get it all; bank failures, recession and inflation.