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Mervyn King: The age of banking innocence is over, and the long march back to economic stability has started
Report: A long slow haul, Bank governor tells Yorkshire business chiefs » MY first memories of Leeds are from a wet summer in 1958. I was 10 years-old, we lived on the moors above Hebden Bridge, and my father took me to my first Test Match – England against New Zealand at Headingley.
It rained all day on both Thursday and Friday, and, when play started in mid-afternoon on Saturday, on a drying wicket, New Zealand were bowled out by Laker and Lock for 67. So I became a slow bowler.
I was taught to bowl – slow left arm – at Old Town Primary School by the headmaster, Alfred Stephenson. During the morning break, he would mark the wickets in chalk in the playground, and draw a small circle exactly on a length.
If we could pitch the ball within that circle, he would give us a farthing. As we improved, and the payout of farthings increased, the morning break became shorter and shorter – my first lesson in economic incentives, or what is known in the trade as "moral hazard".
Let me move forward 50 years to the events of 2008, and describe the nature of the financial crisis, the steps that governments and central banks have taken to deal with it, and, most important, the implications of recent events for the UK and world economies.
Since August 2007, the industrialised world has been engulfed by financial turmoil. And, following the failure of Lehman Brothers on September 15, an extraordinary, almost unimaginable, sequence of events began which culminated last week in the announcements around the world of a recapitalisation of the banking system.
It is difficult to exaggerate the severity and importance of those events. Not since the beginning of the First World War has our banking system been so close to collapse.
Radical action was necessary to ensure the survival of the banking system. And on the morning of October 8, that action was taken when the Prime Minister and Chancellor unveiled a UK plan for recapitalising the banking system on which the Bank, the Financial Services Authority and Treasury had been working for a while.
Why was radical action necessary? When the financial turmoil began in August 2007, markets for a number of financial instruments, including mortgage-backed securities, dried up.
Most observers expected this closure to be short-lived, and the predominant view was that the crisis was one of (a lack of) liquidity. But, as time passed and markets did not re-open, it became clear that the problem was deeper seated, and concerned the solvency of the banking system and the sustainability of its funding model.
Confidence in the banking system had also eroded as the weakness of the capital position became more widely appreciated. But it took a crisis caused by the failure of Lehman Brothers to trigger the coordinated government plan to recapitalise the system.
It would be a mistake, however, to think that had Lehman Brothers not failed, a crisis would have been averted. The underlying cause of inadequate capital would eventually have provoked a crisis of one kind or another somewhere else.
So where does this leave us? The recapitalisation plan is having a major impact on the restoration of market confidence in banks, but we are far from the end of the road back to stability.
The plan to recapitalise our banking system, both here and abroad, will I believe come to be seen as the moment in the banking crisis of the past year when we turned the corner.
As concerns about the viability of our banks recede, they should regain the confidence of the market as recipients of funding. There are already some signs of greater activity.
But the age of innocence – when banks lent to each other unsecured for three months or longer at only a small premium to expected policy rates – will not quickly, if ever, return.
In itself that does not affect the ability of banks to fund lending, but confidence has been badly shaken after the traumatic events of the past few weeks.
New sources of funding will develop only slowly, although the temporary government guarantees of new lending to banks will help. So it will take time before the recapitalisation leads to a resumption of normal levels of lending by the banking system to the real economy. And we cannot assume that there will not be problems in other parts of the financial system.
With the plan for recapitalisation in place, the focus of attention has moved to the outlook for the UK and world economies.
Over the past month, the economic news has probably been the worst in such a short period for a very considerable time. Why has the outlook deteriorated so quickly?
The banking crisis dealt a severe blow to the availability of credit. Growth in secured lending to households fell to its lowest level in more than a decade.
At the same time, consumer price inflation, our target measure, has risen from around its two per cent target at the beginning of the year to a worryingly high rate of 5.2 per cent in September.
Oil and other commodity and food prices have all been rising very rapidly. In those circumstances, it was sensible to allow those price changes to be absorbed by movements in consumer prices. The alternative would have been an even sharper slowdown in the economy.
It is surely probable that the drama of the banking crisis, which is unprecedented in the lifetime of almost all of us, will damage business and consumer confidence more generally. But two pieces of good news should temper the gloom.
First, the banking system will be recapitalised and, in due course, the banking system will resume more normal lending, although by normal I do not mean the conditions that prevailed prior to August 2007.
Second, oil prices have now fallen from a peak of $147 a barrel only three months ago to around $70 today. And wholesale gas prices have now also started to follow oil prices down. That will help to support the growth of
real incomes as well as bringing down inflation.
So, what should the Monetary Policy Committee do now? It must continue to set interestrates in order to meet the two per cent inflationtarget, not next month or the month after, but further ahead when the impact of recent developments in both credit supply and world commodity prices will have worked their way through the economy.
This is the time not to abandon but to reinforce our commitment to stability. The slowdown in demand, and the recent falls in energy prices, will bring inflation back towards the target.
The downturn in the economy will affect not just monetary policy, but fiscal policy, too. The cost of supporting the banking system will inevitably raise the level of national debt. Managed properly, however, such a rise in national debt need not prove inflationary.
Indeed, within a reasonable period it should be possible for the Government to reduce its stake in the banking system, for example, by selling units in a Bank Reconstruction Fund, and repay the additional debt that had been issued. That is one difference between past increases in national debt in times of war and the increase now to
pay for recapitalisation of the banking system.
Let me take you back to 1958. In the very first television interview given by a Governor of the Bank of England, Cameron Cobbold explained national debt to Robin Day on Tell the People, the highlight of ITN's Sunday evening schedule 50 years ago. This is how their exchange went:
Cobbold: "The National Debt represents the sums of money which the Government have over the years borrowed from the public, mainly in this country and, to some extent, abroad. That is really the amount of expenditure which they have failed over the period to cover by revenue."
Day: "Have we paid for World War Two?"
Cobbold: "No."
Day: "Have we paid for World War One?"
Cobbold: "No."
Day: "Have we paid for the Battle of Waterloo?"
Cobbold: "I don't think you can exactly say that."
On this occasion, we should have little difficulty in evaluating when we have paid for the recapitalisation.
However, we now face a long, slow haul to restore lending to the real economy, and hence growth of our economy to more normal conditions.
The past few weeks have been somewhat too exciting. The actions that were taken were not designed to save the banks as such, but to protect the rest of the economy from the banks.
I hope banks will come to appreciate, just as the New Zealanders at Headingley in 1958, the Yorkshire virtues of patience and sound defence when batting on a sticky wicket.
I have said many times that successful monetary policy would appear rather boring. So let me extend an invitation to the banking industry to join me in promoting the idea that a little more boredom would be no
bad thing.
The long march back to boredom and stability has started here in Leeds.
This is an edited extract of a speech Mervyn King delivered at the Royal Armouries, Leeds, to the CBI, Institute of Directors, Leeds Chamber of Commerce and Yorkshire Forward.
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Saturday 26 May 2012
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