Tuesday, September 30, 2008

The American administration has failed to push through Congress its propsal for a $700 billion bail-out of the banking sector. This has profound implications for the economy, not only in the US, but throughout the world.

Members of the House of Representatives appear to have been lobbied successfully by their electorate, which appears to perceive the bail-out simply as a means of keeping some fat cats in the banking industry in clover. It does not take much thinking to see that that can, at best, be only a partial view. Bankers may, in large measure, have caused the crisis - but that doesn't mean that they have the resources to avert it. The need for a large bail-out doesn't come primarily from money that has disappeared into bankers' pockets - most of the problem is that the money was never there at all, and all of us, as Joe Public, managed to kid ourselves that it was.

There is gridlock in the money markets. Banks will not lend to each other because they fear that they will not be repaid. This means that banks themselves have little resource that they can lend to end users. House buyers find mortgages hard to come by. Firms find that they cannot raise the capital to invest in new equipment. The reduction in investment exacerbates the problem of a stagnating economy. With that, prices on the world's stock markets are plummeting, and that has adverse implications for people's pensions and other savings. So consumer demand is diminished. We are caught in a vicious circle.

The $700 billion bail-out was an attempt to break out of that. For sure, it was going to involve tax hikes in the future. But for sure, if there is no bail-out, people will be hit in the pocket in other ways - through their pensions and savings, and through a prolonged period of recession. We have lived beyond our means for several years, and now - through the tax system or otherwise - it's payback time.

The tax option is probably the best of a bad set of options available. It can at least ensure some degree of fairness. It should be accompanied by a new and much tighter form of regulation in the financial sector. Hopefully the proposal will, in one form or another, be revived later this week.

Monday, September 29, 2008

It's less than 2 weeks since HBOS was taken over by Lloyds, and now the Bradford and Bingley is nationalised, with much of the company being sold on to the Santander Bank. Santander also own Abbey, and so this move further increases the concentration of activity in the banking sector in Britain. In so doing, it makes even more necessary a wholesale review and reform of regulation for the financial services industry.

Friday, September 19, 2008

The US authorities are engineering a plan to stabilise the financial markets. From what we know already, it seems that this might involve legislation that forces lenders to renegotiate debt repayments with homeowners who have been struggling to pay their mortgages. So much, so sensible.

It is also suggested that the government might set up an agency that would take on the bad debt that has come from banks offering mortgages in the sub-prime market. This news has really cheered up the stock markets in a big way - with the FTSE100 gaining over 7.5% this morning. Such a big rescue may well be necessary, but it would not all be good news. It would have adverse implications for taxes in the future. People know that, and they will start spending less now in anticipation of a higher tax burden. That will slow down and maybe even postpone the economic recovery.

Such a rescue would also have implications for the regulation of the banking sector in the future. If government bails out banks, it takes away the disciplines of the market. If it does this, it must impose some rather stringent regulation in order to ensure that banks do not take excessive risks. The whole regulatory framework for financial services is set to change in a massive way.

Wednesday, September 17, 2008

The news on financial institutions keeps coming thick and fast. AIG has been bailed out by the US government, in what is effectively a nationalisation. Meanwhile in the UK, HBOS (the merged Halifax and Bank of Scotland company) has been hit hard by an assessment by Standard and Poor's (a major credit ratings agency) which deemed it to be the most vulnerable of the British banks. The value of shares in HBOS has collapsed dramatically in recent days, and early today had fallen by a further 40%. The latest news is that Lloyds are contemplating a takeover. Shares in HBOS have recovered somewhat since this news broke.

With rumours sending share prices of some banks spiralling downwards, it is not surprising that other financial institutions are quick to seize the opportunity of takeovers on the cheap. It is becoming clear that one thing to emerge from this crisis will be a massive increase in concentration in the banking industry, with far fewer banks competing against each other. The dilution of competition as a discipline on banks' behaviour will bring about its own issues of regulation.

Tuesday, September 16, 2008

After the relative calm of late July and August, stock markets have been thrown into a frenzy once more, with the FTSE100 dipping below the psychologically important 5000 barrier. This has followed the weekend's dramatic events on Wall Street, which saw the investment bank Lehman's being forced into bankruptcy, Merrill Lynch being taken over by the Bank of America, and the American International Group (AIG) of insurers widely tipped to be the next financial giant to come under pressure.

The troubles of the global financial sector are by now well documented, and the events of the last few days just go to reinforce the fact that we are now living through the worst crisis of this kind for many decades. The scale of the disturbance within the financial industry makes clear the fact that these events will have serious ramifications for the real economy.

Some observers are pointing to the Clinton administration's repeal of the Glass-Steagall Act which, until 1999, forced investment banks and commercial high street banks to be separate entities. This Act, while in force, ensured that bankers did not take inappropriate risks with funds deposited by the public. The repeal of the Act, following prolonged and intense lobbying from the banking sector, allowed banks to take advantage of economies of scale and scope, and also allowed American banks to become more effective in competing internationally. The repeal should not have introduced new hazards - credit ratings agencies (CRAs) should have been reporting on risks to the main financial regulatory body in America, the Securities Exchange Commission (SEC) who would then act on the information. In practice, the CRAs may have failed to maintain enough of an arms-length relationship with their clients, and the SEC may have failed adequately to anticipate this. Repealling Grass-Steagall hasn't helped matters for sure, but that fact should not serve to hide some pretty serious failures that have happened elsewhere in the regulatory system.

The key questions are: how these failures arise (I suspect that the incentives people face are not always aligned with what is best for society); whether the failures are endemic (I suspect not); and what institutions (regulations, mechanisms) can be put in place to prevent them. An overhaul of the governance of firms in the financial sector is needed, ensuring that the incentives that workers face are aligned with the broader need for these firms to conduct their affairs in a socially responsible manner. Economists with expertise in personnel economics (and the application of principal-agent models in the workplace) should be at the forefront in the design of these reforms.

Thursday, September 04, 2008

The Bank of England has kept the interest rate at 5% this month. As I have argued on this blog earlier today, I think a cut would have been timely. Downgrade your growth forecasts for the first half of next year.
The Bank of England's Monetary Policy Committee (MPC) is set to make its latest monthly decision on interest rates later today. Many pundits suggest that the MPC is unlikely to cut rates given the continued threat of inflation, but that cuts are likely in the months ahead.

We are on the point of entering recession. Inflation has risen to above 4%, and that is a problem in the eyes of many members of the MPC - they are, after all, briefed to keep inflation close to its target level of just 2%. But oil prices have fallen back quite sharply over the last month, and the recession is likely to dampen price increases further in the domestic economy.

It takes changes in the interest rate about 6-9 months measurably to affect economic activity. The MPC needs to be looking ahead to the spring of 2009 - by which time the threat of inflation should have receded and - without a fillip - the economy will likely have suffered three quarters of non-positive growth. Given what has happened in recent weeks to the price of oil, the Committee should not delay further in cutting interest rates.

Tuesday, September 02, 2008

A stamp duty 'holiday' has been announced. This means that, for the next year, people buying houses costing up to £175000 will not have to pay stamp duty on their purchase. Up to now, stamp duty has been payable on all houses costing over £125000. For the next year, the 1% rate of stamp duty will kick in at the higher £175000 level.

According to the Nationwide Building Society, the average house price in the UK is (to the nearest thousand pounds) £175000. The move on stamp duty is therefore clearly aimed at helping most directly people in the bottom half of the housing ladder. Others will benefit from a ratchet effect: as first time buyers decide to buy their own homes, sellers will find that they can trade up, and so on up the chain.

The stamp duty change is just part of a package of measures to breathe new life into the housing market. Households on incomes below £60000 per year are to be offered loans that are interest free for the first five years. At the end of the five years, they will have to pay a fee - and the success of this initiative will doubtless depend crucially on the (hitherto unknown) details of that fee.

It is to be hoped that this package of measures will deliver the stimulus that the housing market badly needs. Ultimately, though, people will start to buy into housing once they believe that house prices are no longer falling. They are unlikely to be impressed by a tax break worth £1750 if they think the value of their new home is likely to fall by more than that amount over the coming months. And they will not respond to a tax break if they think that it is still going to be available in the future. So we may have to wait till towards the end of the tax holiday (and the tax holiday will indeed have to come to an end) before many people decide to take advantage of the reduction in stamp duty.

Monday, September 01, 2008

Chancellor of the Exchequer, Alistair Darling, has hit the headlines over the weekend by claiming that the economic situation may be the worst that we have faced for 60 years. At the same time, David Blanchflower, the most dovish of the members of the Bank of England's Monetary Policy Committee (MPC), has gone public on his views that unemployment could top 2 million by the end of the year, and that the Bank needs to cut interest rates further.

Other members of the MPC may feel as though there is a pincer movement here, and that, for the first time since the Bank was given independence, we are seeing some real political interference in the process of setting interest rates.

Mr Darling's comments have had an immediate effect on the exchange rate, with speculators selling sterling like hot cakes. The value of the pound has collapsed to a two year low against the dollar. This, in itself, should do something to help the ailing economy, as our exports become cheaper relative to those of other countries.

The Chancellor has received a bad press following his comments. Perhaps he has indeed been politically naive. But perhaps, given the (sensible) decisions made in 1997, he is now using the only means left open to him to influence monetary policy - without being seen to do so.

Life is tough when someone makes you the captain just as you head for the rocks, especially when you aren't given control of the rudder. As the Welsh say, 'poor dab'.