Economy

Part of the debate – in the House of Lords at 4:21 pm on 3rd November 2008.

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Photo of Lord Lawson of Blaby Lord Lawson of Blaby Conservative 4:21 pm, 3rd November 2008

My Lords, at the heart of this debate lie two questions: how did we get into this mess and, now that we are in it, what should we do about it? I will deal briefly with both.

Part of the answer to the first question is the inescapable working of the economic cycle, which, as Keynes pointed out in the 1930s, is in large measure a creature of the credit cycle. What has greatly magnified the credit cycle since his day is the massive growth of consumer credit of all kinds. The present Prime Minister's constant boast—even as late as his Budget Statement last year, when the extent of the housing bubble should have been evident even to him—that he had abolished the cycle and put a permanent end to boom and bust, showed not merely astonishing economic ignorance, but it made things worse; for, to the extent that people believed him, and I suspect that many did, it reinforced the unwarranted over-optimism of borrowers and lenders alike. It was an invitation to be imprudent.

Not that that exonerates the equal folly of the bankers who, whether out of ignorance or greed, also threw prudence to the winds. Of course, the history of banking is punctuated with examples of this. Given the recurring phenomenon of banking folly and the massive growth of overall debt, the need for adequate banking supervision is greater than it has ever been, because the failure of core banks can be a threat to the entire economy. That is why there has always been a need for bank supervision, which requires at its heart that banks should possess adequate capital in relation to the risks that they take.

We have seen worldwide a massive failure of bank supervision as banks have been permitted to boost their profitability by taking bigger risks—increasingly, risks they were unable to evaluate—while diminishing their non-earning capital. While the so-called Basel system, which was intended to prevent this, has been defective, the buck stops with national authorities, where the blame properly lies. This, above all, needs to be remedied.

The pattern of failure has not, of course, been uniform, although it has been extensive. Among major financial centres, Spain probably comes out best and the UK almost certainly worst. The FSA has already accepted that it was asleep on the job in the case of Northern Rock. However, in fact, it was asleep on the job across the board. Indeed, at least until very recently, if you looked at the FSA website and clicked on "What we do" you would find a lot of things, but no mention at all of bank supervision. That, at least, was honest, I suppose.

As some noble Lords will recall, when I was Chancellor I was concerned about the inadequacy of bank supervision in this country, which is why I created the Board of Banking Supervision with the Governor of the Bank of England as chairman and the best former bankers I could find as independent members. Regrettably, when he became Chancellor, Mr Brown first removed any connection between the board and the Bank, then downgraded the quality of the independent members and then abolished the board altogether, leaving the task entirely to the FSA under the profoundly mistaken belief that financial regulation and bank supervision are the same thing. They are not. Bank supervision is much more like high-level auditing than financial regulation and requires totally different skills and totally different personnel. As a result, both here and indeed virtually worldwide, there has been a complete failure of bank supervision, leading to banks being hugely undercapitalised for the risks that they were taking; hence, the severity of the present crisis.

Now, the fire brigade has had to be activated and a massive rescue operation put in place to recapitalise the banks. I am very happy that that has happened. However, it clearly needs to be followed by the creation in all the major financial centres of an adequate system of bank supervision for the future. It is this, rather than a new Bretton Woods or a new international financial architecture, that is required. Talk of a new Bretton Woods and so on is just claptrap, and most of those who utter it have very little idea of what they mean by it.

Two things in particular will be assisted by getting bank supervision right. The widespread banking folly that we have seen has been caused in no small measure by a form of Gresham's law of lending, which has meant that bad or imprudent lending has driven out good or prudent lending. This happens because prudent banks see their market share gradually fall as that of imprudent banks rises, so eventually they decide to protect their market share by emulating the imprudent practices that they had previously eschewed. Adequate supervision would nip that process in the bud.

Again, at present there is understandable concern at the wide range of institutions that have had to be rescued in one way or another by the authorities here and in other countries. That became necessary because the core banking system was allowed to become so undercapitalised and thus so fragile that the collapse of non-core institutions might well have brought it down. Adequate supervisory requirements, properly enforced, would have ensured that the core banking system was strong enough to allow non-core institutions, if they made their mistakes, which they did, to go to the wall, which would have been very much better. Therefore, it is clear what needs to be done to avoid a repetition not of banking folly but of banking folly on the scale that we have seen.

What, finally, do we need to do now over and above the rescue facilities that, happily, are already in place? There is of course no way that we can escape the recession that is already upon us. The greater the binge, the greater the hangover, and this has been the greatest consumer credit binge ever.

It is not just banks that need to rebuild their balance sheets; consumers do, too. The fool's paradise of debt-fuelled prosperity has to end as consumer indebtedness—which, incidentally, as a proportion of disposable income is far higher in this country than even in the United States—is brought back within the limits of prudence.

However, the recession, although inevitable, can and should be mitigated. The inflationary threat will one day re-emerge but for the time being it has gone. As other speakers have already said, the time has now come for significant further cuts in interest rates, preferably on an internationally concerted basis. Among other things, this would greatly help confidence, which is always important at a time such as this.

I am not persuaded, however, that an attempted fiscal stimulus is desirable. Of course the budget deficit will rise as the recession erodes tax revenues and increases benefit payments, and that is no problem. But in the UK in particular, where, under this Government, the underlying fiscal position has deteriorated alarmingly, discretionary action to cause it to deteriorate still further would, in my judgment, be unwise. Public spending increases, other perhaps than accelerating sound infrastructure projects already in the pipeline, would be particularly unwise, slow to come into effect and hard to reverse, unlike interest rate cuts.

Temporary tax cuts, although less harmful, are probably also unwise. A temporary cut in VAT, although much talked about, would be prohibited under European Union law. But even if it were not, the numbers need to be borne in mind. As my noble friend Lady Noakes has pointed out, under this Government, the savings ratio has plummeted from 10 per cent to virtually zero as a proportion of disposable income. A recovery of that ratio is both inevitable and necessary. Even if it returns only half way, to 5 per cent, that implies a reduction in annual spending of roughly £50 billion, a sum way beyond the prudent or maybe even practicable capacity to borrow, over and above what will need to be borrowed as it is.

I believe that any plausible, discretionary fiscal loosening would, at best, be of trivial use now while adding to the problems that already lie further ahead on this front. In short, the right answer—in so far as there is one, for the worst recession since the war is now unavoidable—is sizeable interest rate cuts now and, above all, proper banking supervision to prevent a recurrence on anything like this scale in future. And, of course, there should be no more nonsense about the end of boom and bust.