Cable: To halt the bank tsunami, slash interest rates

October 5, 2008 4:36 PM
Originally published by UK Liberal Democrats

The Chancellor should write to Mervyn King asking that the monetary policy committee assume a temporary central role in countering the economic crisis, thus allowing for large interest rate cuts says Liberal Democrat Treasury spokesman, Vince Cable.

The rules of financial seamanship devised for calm waters and the occasional moderate storm are not proving much use in the face of the tsunami bearing down on us. Panic is the all-too-human reaction. And fear.

Leadership is required. Leadership will not come from a committee of economic ministers standing behind the chancellor, debating where to steer and fighting for control of the tiller. There has to be a sense of policy direction. Fortunately there are lessons to be learnt from previous financial tsunamis.

The first relates to monetary policy. There is now a severe monetary squeeze taking place, even though official interest rates are negative in real terms in the United States and low elsewhere, including Britain. Banks are hoarding cash and trying to avoid all but the safest customers. After the disappearance of new mortgage lending, lines of credit are being pulled from companies and individuals.

History teaches us that interest rates should be slashed during a banking crisis to stave off deep recession. This has happened in the United States, but not in Britain. The approach of the Bank of England's monetary policy committee, dictated by its mandate, is to balance deflationary against inflationary risks with, in practice, occasional small adjustments in interest rates. The committee is in danger of becoming irrelevant in an environment where short and medium-term inflationary risks are massively outweighed by the danger of a once-in-a-lifetime collapse of the financial system.

Central bank independence must be maintained - not least because, after the crisis has passed, intervention by governments could have big inflationary consequences. What is required is for the chancellor to write to the governor saying that on a temporary emergency basis the committee should assume a central role in countering the crisis with a large cut in interest rates. A big cut - conceivably as much as two percentage points - would have a big psychological impact on consumer and business confidence when it is most needed.

Second, a far-reaching approach is required for the banks. Hitherto the Bank has provided unlimited liquidity (at a penalty rate and against sound security). Beyond that, banking crises have been dealt with on an ad hoc basis with, now, two nationalisations, an officially orchestrated merger (Lloyds TSB/HBOS) and various takeovers (Alliance & Leicester by Santander; smaller building societies folded into Nationwide). That approach has been right. The danger, however, is that the collapse in investors' confidence in banks could result in the remaining high street banks being picked off, one at a time, resulting in a succession of messy nationalisations or forced mergers.

There is a case for a more systematic approach. A good model for managing a banking crisis is Sweden. After the collapse in the property market in the early 1990s, not dissimilar from America and Britain today, the banks had insufficient capital and there was a confidence crisis. The focus was on recapitalising the banks. Debt-equity swaps and new equity issues were generated under a government-managed programme. The government either nationalised banks or acquired a stake in them. When the banks' balance sheets were sufficiently robust and economic conditions had improved, the government sold its stake (and made money for the taxpayer).

A variant of the Swedish model could be applied here. One step would be to help banks to raise fresh capital from the markets. At present banks cannot make rights issues because share prices are depressed and confidence has gone. Even in better conditions, underwriters have been left with a large chunk of shares. Were the government to agree to act as underwriter (for a fee) it is much more likely that capital would be raised or, if not, the government would acquire convertible preference shares and hold them up to the underwriting limit. The shares could be sold later, as in the Swedish case, but in the meantime they would generate an income for the taxpayer.

The financial crisis has touched only the edges of the real economy. Nobody seriously expects that to last. There has to be a coherent government response starting with the most vulnerable part: housing. It would be wrong to try to prop up house prices which still have some way to fall to restore affordability. A better approach would be to use the £8 billion the government has committed to social housing for social landlords to buy surplus land and property at the hefty discounts being offered. A large programme of social house building and property acquisition would help to reduce housing need and revive the sheltered house building industry while creating a public sector asset.

Beyond that lies the need for a new regulatory deal with the financial community. This should not be done when the public mood is understandably for hanging, drawing and quartering anyone connected with banking, although there is scope for some early practical reforms linking bank capital requirements to the economic cycle. There will be time enough for post-tsunami reconstruction. The priority now is disaster management.

Vince Cable is the Liberal Democrat Treasury spokesman