Tuesday, October 21, 2008

The OECD today reports that income inequality has, since 2000, declined faster in the UK than in any other member country. This gain has been largely due to a rise in employment.

In other recent work, I have investigated what the current skill set of young people in Britain implies for the distribution of income over the coming decades. For the most part, skills of young people have risen by about 7 per cent since the mid-1980s and the mid-2000s. But they have increased by much less for those in the bottom 20 per cent of the skills distribution - and there is evidence that they have declined for those in the bottom 5 per cent. These findings suggest that the distribution of income is likely to widen over the coming couple of decades, as young people enter the labour force.

While the overall improvement in skill is, of course, something to be welcomed, more still needs to be done, and urgently so, to support those in the bottom tail of the distribution.

Monday, October 20, 2008

Here is some good news. The LIBOR has started to fall. The overnight LIBOR has fallen to just 0.19 percentage points above the Bank of England's official interest rate - a week ago it was 1.3 percentage points above. The decline in the three month LIBOR is slower - this rate now stands at 6.16% - but here too there is progress. This should mean an easing of the blockages in the market for credit that we have seen in recent weeks.

Recession still looms. But at least monetary policy - a major tool for dealing with recession - once again stands some chance of working.

Thursday, October 16, 2008

The London Interbank Offered Rate (LIBOR) of interest at which banks make three month loans to each other has, despite the massive bail-out programmes launched internationally over the last couple of weeks, stayed at over 2 percentage points above the Bank of England's base rate. This indicates that banks are still spectacularly unwilling to lend to each other - despite all the guarantees that government has now put in place.

With the LIBOR failing to fall much after the base rate was cut by half a percentage point last week, businesses are not encouraged to invest. Cuts in the interest rate at which the Bank of England makes overnight loans to commercial banks cannot stimulate the economy if they are not fed through to other interest rates like the LIBOR.

Fundamentally, banks are now holding on to their assets in the form of cash, rather than lending out. In the absence of confidence, this is a 'once bitten twice shy' approach - but it is not helping the economy recover.

Desperate times call for desperate measures. Perhaps we need to think once more of regulating the reserve assets ratio (the ratio of cash held by banks relative to the banks' total assets), stipulating a range (maximum as well as minimum) within which this ratio should lie.

Monday, October 13, 2008

The government's bail-out of the banking system has taken shape dramatically this morning, with the announcement that the Royal Bank of Scotland, LloydsTSB and HBOS have all sought capital investment from the taxpayer. In the case of the Royal Bank of Scotland, the government's stake will amount to 60% ownership of the company - effectively a nationalisation. In the case of the other two banks, which are set to merge, the stake will be about 40% - enough to provide the government with considerable influence.

From the banks' perspectives, there are strings attached to these investments. Directors will not receive bonuses this year, and future bonuses will take the form of shares rather than cash. The Lloyds TSB and HBOS investment is conditional on the merger going through. The terms of the merger have, however, been renegotiated in light of the fall in the value of HBOS shares since the merger was announced - instead of receiving 0.83 Lloyds TSB shares for each HBOS share, shareholders in HBOS will receive just 0.605 Lloyds TSB shares.

The issue of bonuses needs a more thorough look though. One of the key underlying causes of the present crisis is that the incentives provided to senior bankers have not been properly aligned with the long term interest of the banks themselves. Perhaps these incentive mechanisms were designed by the wrong people - or at least by people who needed better to understand the information deficiencies (opportunities to hide unpleasant surprises) that accompany the new breed of financial securities.

The government intends to use its position as majority or large minority shareholder to restructure the banks, then to sell off their stake to the private sector. It is not clear how long the restructuring process will take, nor how long we will have to wait for the economy to reach a position where private investors see banks as an attractive investment. An optimistic estimate might be 3 years. It could take more than 10. Whatever, the restructuring needs to include reform of remuneration practices within banks.

This needs to take on board the lessons of principal-agent theory. One interpretation - and one that has been well understood in the past - of this theory is that it is all about how to incentivise people. Another aspect of the theory has been much less well understood, though - and that has to do with how to incentivise people in the presence of information deficiencies and uncertainty. There are some lessons that need to be translated into action.

Meanwhile, governments in the Eurozone have agreed a package that guarantees loans that banks make to each other, and which provides assurance that public investment of capital will be made in banks that are struggling. The package resembles the British solution - which released £200 billion for loans to banks as well as providing up to £50 billion for capital investment. It remains to be seen exactly how the European solution will work - inevitably the need to work across borders renders matters complicated here.

Markets have responded positively to these moves.

Wednesday, October 08, 2008

The Bank of England has cut its interest rate by 0.5% - a day ahead of the expected announcement of the Monetary Policy Committee's decision - in a coordinated move by central banks that includes similar rate cuts in the USA, the Euro area, China and elsewhere. The cut should provide help bolster the demand for credit, hence investment, and hence overall spending, as the downturn threatens to turn into a severe recession. It is a very belated, but nonetheless welcome, move. It is unlikely to be the last cut in interest rates of the year.

An equally serious problem, however, is that the supply of credit remains frozen. The measures announced by the government earlier today - which involve it in taking partial ownership of commercial banks and providing banks with access to a huge amount of extra loans from the public purse - still need to be accompanied by conditions that enable banks to have renewed confidence in each other. Providing an institution to insure debts, and financing that institution, is one measure that I have mentioned before on this blog. A wholesale reform of the regulation of the financial sector is another. These are exciting, albeit traumatic, times indeed.
Bank A wishes to take a loan from Bank B. In normal times, Bank B would love to make the loan, since rates of interest are attractive. But there is a problem. Call that problem a trust gap. Bank B simply does not trust Bank A to be able to repay the loan.

In normal times, defaults on loans are quite rare, and banks insure themselves against such defaults by way of a markup on the charges they make for all loans. Just as shopkeepers make an allowance in their pricing decisions for the fact that some goods will perish while in stock, banks make an allowance in setting their borrowing terms. These times are not normal, however, and there is a need for a more formal type of insurance to plug the trust gap.

We might expect the need for such insurance to be met by the creation of a company specifically to offer it. Surely such a company would offer an attractive proposition to investors. But solutions of this type are unlikely to work in the present climate, simply because banks are not lending, and so they would not lend to a company setting itself up to provide this sort of insurance.

The government has, this morning, announced its willingness to buy shares in the major banks, up to the value of £50 billion. Details of exactly how the scheme will operate have still to be worked out. There are hints that the money will be available to banks that agree certain conditions - including conditions on remuneration of their own executives. That is as it should be. But it is also crucial that the conditions should include a means of breaking through the gridlock that has thrown the banking system into its present state of sclerosis. A start might be to require banks, with government as facilitator, to finance the creation of an institution that effectively insures their own business.

Tuesday, October 07, 2008

The Bank of England's Monetary Policy Committee (MPC) meets again this week to decide on the Bank's interest rate. With the pressures of inflation starting to erode (with falls in oil and fuel prices), the onset of recession should surely be at the forefront of the committee's mind. That suggests that they should cut interest rates in order to stimulate the economy.

And indeed they should. But the beneficial effect of such a stimulus is likely to be muted. In normal times, the cost of borrowing is a major factor in determining the extent to which people and businesses will borrow in order to finance their expenditure. To some extent, the same is true today. But these are not normal times. Another huge barrier to borrowing is the availability of credit. People aren't borrowing now, not so much because loans are expensive, but because they are not even available in the first place. The banking system is largely gridlocked by a general lack of confidence.

The authorities have been making funds available to the banks in an attempt to get out of this gridlock. Probably too much of this help has been in the form of short term loans, and not enough in the form of medium to long term loan facilities. Curiously, monetary policy is now as much about such detail as it is about the interest rate deliberations of the MPC.
At its second attempt, Congress passed the $700 billion bail-out. The markets have not responded positively, as further bank crises and confused policy announcements in Europe have cast yet more gloom on the outlook.

The most recent policy moves in Europe have aimed at securing deposits - ensuring that people who save their money in a bank will be able to access their savings in full, whatever might happen to the bank. The authorities have also made substantial loans available to the banking sector. For the most part, these loans have been short term, day-to-day, loans. The American bail-out makes longer loans available. Perhaps European policy needs to be tilted a little in that direction too.