Tuesday, September 18, 2007


(not Charlton related)

I began studying for an economics degree in October 1992. It was an unusually opportune time because just two weeks earlier, the pound had crashed out of the ERM despite the Chancellor's attempts to raise interest rates from 10% to 15% in the space of a day.

Not surprisingly the first essay we were set discussed the somewhat novel (to us at least) concept of 'credibility' as it pertained to central bank policy. For some reason, it has stuck in my mind long after I realised that most of what I learned at university was bunk, and not just because I tested the tutor's humour tolerance by describing the episode as Lamont-able (he laughed luckily, but then again he supported Ipswich).

It seems us credibility theorists have had to wait 15 years (to the day amazingly) to watch it being tested to the full again. Back in 1992, George Soros (who is wealthier than some central banks, and for good reason) knew full well that the government and the country would prefer to surrender to a collapsing pound (and inflation), rather than tolerate the severe recession and unemployment that 15% interest rates would have implied. He knew they were not credible, and he was right.

Incredibly (no pun intended), Gordon Brown has given the go ahead for the Bank of England to effectively underwrite the entire UK banking system. Let's say (as looks increasingly likely) one or both of Alliance & Leicester and Bradford & Bingley confirm they are facing similar problems financing operations from the wholesale markets. Is he going to allow those banks to fail, whilst continuing to uphold his support for Northern Rock? Are Northern Rock savers going to benefit from an odd version of 'first mover advantage'?

The answer is "of course not" to both questions. But what if other banks begin to fail also, then the government/Bank of England faces the problem that it might conceivably be unable to afford to bail them out, in the absence of crushing tax rises and a certain recession. If they lose their credibility at that point, they risk a full-scale run on the banks, not a contained one. Even to the extent they can afford it, the implication is that the hard-earned taxpayer's money will be spent buying a portfolio of buy-to-let mortgages. Alistair Darling as your landlord? Now there's a terrifying prospect.

Once again their credibility is being tested, and the smarter investors know it (witness the final-hour collapse in Alliance & Leicester's share price on Monday). This clearly threatens the supposed independence of the Bank of England (upon which so much of the UK's apparent economic success has been founded), and potentially the government itself, given that it is so patently a political decision. After all, weren't we told that Northern Rock was solvent just last Friday, implying the 'silver savers' queuing were panicking unnecessarily? It's been pointed out that some of them were old enough to remember the 1929 crash. So what's changed?

I'm writing this post before markets re-open in London on Tuesday, and by the time I wake markets may have re-found their poise, and the panic may be over for now. But if the truth be told, Northern Rock should have been allowed to fail and the potential ramifications of it not having done so (yet), are potentially far more grave. Savers need to learn a lesson here too: Don't lend money to a bank that issues 125% mortgages and expect it to be risk-free, and more importantly, don't put all your eggs in one basket. Be prepared for the 'Black Swan'.

I suppose on the one hand, it was inevitable that having done so much to emphasise the City's role in the UK economy to such a disproprotionate degree, that Gordon Brown would be so desperate to save what's left of his 'economic miracle.' More curiously, in the wake of the failed bombings, foot-and-mouth and now this, you have to wonder if Tony Blair knew something.

Then again, it's ironic that those that are critical of his actions today are those that work in the financial sector, well-aware of the enormous 'moral hazard' he is potentially generating. Meanwhile over here in the US, the former Federal Reserve Chairman Alan Greenspan is conducting a book tour, merrily passing comment on the destructive result of the form of 'moral hazard' he himself generated after tech blew up in 2000. As they say in New York, he's got some chutzpah.

It's not the City's fault after all that thanks to the decimation of manufacturing, that in their wake, all we have left is expertise in pharmaceuticals, defence, and seemingly lots of companies selling ringtones. They half-created this mess, but can probably live with the bonus reductions and job losses that are coming. But in common with all of us, they probably could do without the UK risking becoming the next Argentina.


At 3:56 PM, Anonymous Anonymous said...

The 125% ltv finance is not the problem. They are not 125% mortgages, they are 95% mortgages with a 'cheap' unsecured loan up to a maximum of £30k. So you would only get 125% of total purchase price if the property costs no more than £100k, and we all know that you cannot buy much for that. Also the profit margin in these loans more than outweighs the risk. It must do as the queue of banks offering these deals has grown in the last 12 months to include many of the major high street lenders.


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