Economy — Debate

Part of the debate – in the House of Lords at 11:32 am on 5th February 2009.

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Photo of Lord Eatwell Lord Eatwell Labour 11:32 am, 5th February 2009

My Lords, I begin with a quotation:

"This is the first financial crisis of the global age. And there is no clear map that has been set out from past experience to deal with it ... we're learning all the time".

That was the Prime Minister speaking in Davos on 31 January. His statement was important, for it reminds us that no one has the perfect answer to all the complex problems of the current economic turmoil. Anyone who says that they know exactly what to do is either a fool or trying to fool you.

The Government's response to the crisis has been a learning process. The stuttering start in dealing with Northern Rock has been followed by the smooth operation to rescue Bradford & Bingley and, of course, by the development of the special resolution regime to be established by the Banking Bill now being discussed in your Lordships' House. The first investments in the banks were absolutely vital to save the industry from collapse, but they were too expensive and did not go far enough, hence the more recent and better designed investments and the guarantee scheme. The £20 billion boost to demand at the time of the Pre-Budget Report will, I believe, need to be supplemented and developed in the Budget itself.

A similar learning curve can be seen in the United States: first, the allocation of funds to the TARP to buy up "troubled" assets; then, the funds were switched into America's own version of the bank bail-out; then, some of the funds were used to make loans to the car manufacturers; and now, the purchase of troubled assets is back on the agenda again, together with a trillion-dollar boost in demand. In Germany the Finance Minister first criticised British policy as "crass Keynesianism", but then he announced a €50 billion fiscal boost in infrastructure spending, double the size of Britain's Keynesian programme. But there are still some carping voices which appear to have learned nothing. Mr George Osborne, for the Conservative Party, remains wedded to the idea of a balanced budget, just as some in the Republican Party oppose the very concept of President Obama's stimulus package.

Of course the new policy measures involve risks. Direct purchase of assets by the Bank of England, guarantee schemes, financial stimulus by quantitative easing, large fiscal deficits—all these carry very well known economic and financial risks. However, I am convinced that the risks associated with doing too much are as nothing compared with the risk associated with doing too little. If anything, the Government have been too cautious and too constrained by now irrelevant economic orthodoxies. Today, while value for money is a virtue, prudence is a vice. But even as the Government battle the immediate financial mayhem, it is important both that the social consequences of the recession are kept in mind and that we begin to develop a strategy for the future. There must be no "return to normal" if by "normal" we mean the economy of 2006.

I shall comment on just three important social consequences of the recession, the first of which is unemployment. Unemployment will inevitably rise over the next year or so. The Government's policy for the past several years has been to encourage the unemployed to seek work by introducing a range of new training opportunities while reducing the scale and availability of benefits, particularly for those who are not proactive in their search for work. While this may be a productive approach at a time when employment opportunities are rising, this policy has far less value as vacancies fall and unemployment rises. It is important for social cohesion and for the maintenance of demand in the economy as a whole that the costs of the recession do not fall disproportionately on those who are its innocent victims.

The second concerns housing. The Government's measures on housing were described just a few minutes ago by my noble friend Lady Andrews. The repossession of houses belonging to those in mortgage arrears due to loss of jobs and other factors associated with the recession is personally costly and socially inefficient. The banks repossessing homes recover only a small proportion of the value of loans made, at the cost of considerable human misery, and then the burden of housing the newly homeless falls on hard-pressed local authorities. In the face of the crisis in housing finance, what is needed is a special resolution regime for housing to accompany the special resolution regime that we are creating for the banks. A wide variety of measures—temporary payments holidays as proposed by the Government; shared equity; purchase by local authorities and housing associations with conversion of mortgaged property into rented accommodation, aided by the funding proposals advocated by Sir James Crosby—could be part of the housing resolution regime, together with the intention to return properties to securely funded home ownership in the future.

The third, and I suppose that several of us could declare an interest here, concerns pensioners. The fall in share prices and the cuts in interest rates are having a devastating effect on pensioners. It is vital that pensioner living standards are supported and that future saving for retirement is not discouraged. A good place to start would be to build on the old National Savings scheme of "granny bonds"—government-backed bonds offering inflation-proof rates of return to pensioners, hence taking the fear and uncertainty out of saving.

Tackling these social problems will contribute to tackling the recession itself. However, we face a challenge far greater than learning how to deal with the current emergency. If there is no acceptable "normal" to return to, then what should be the shape of our economic future, and how do we get there? One aspect is clear. The growth of financial and business services to more than 30 per cent of gross domestic product has seriously unbalanced our economy. The main reason is that those financial services are not primarily a product of British savings. Instead, the City of London is an offshore trading centre for the rest of the world, uniquely skilled at repackaging risk and return into ever more attractive and ever more complex financial products. That is fine when everything is going well, but Britain is consequentially exposed to enormous overseas risk as UK banks borrow short from abroad and lend long. This must not be allowed to happen in the same way again. From now on, the argument that a particular policy is good or bad for the competitive position of the City will no longer be decisive. Instead, advocates will need to show that any particular policy is good for the competitiveness and the stability of the UK productive economy taken as a whole.

How did these dangerous imbalances arise? Thirty years ago, most loans to businesses and individuals were made by banks or specialist institutions such as building societies. The deregulatory fervour of the 1980s changed all that. Credit markets were "disintermediated", which means that instead of banks acting as intermediaries between savers and borrowers, the markets took over. Investment banks such as Lehman Brothers, Merrill Lynch, Goldman Sachs, RBS and Barclays Capital were all at the centre of this, taking on massive amounts of debt relative to their capital base in order to deal profitably in the complex web of international markets. Guiding their operations were their mathematical risk models: statistical models that assessed the riskiness of their operations against patterns of past market behaviour. The firms claimed that they could manage risky markets by and for themselves, and the Finance Ministers, central bankers and regulators swallowed that claim and let them get on with it. Faith in transparency, disclosure and risk management by firms has been at the heart of financial policy. One of our most urgent tasks is to rid ourselves of this false philosophy. We now know that the biggest risks are systemic risks, such as a general failure of liquidity—risks that no firm alone can manage. In the face of systemic market failures, even the most transparent market is inefficient.

What is needed is what is now called macro-prudential regulation, which tackles the system as a whole. For example, financial institutions must undertake pro-cyclical provisioning. That means forcing banks to raise their reserves in good times—an unpopular policy that we will be told will be bad for competitiveness—and using those reserves as a cushion in bad times. To be truly effective, macro-prudential regulation must escape from the present archaic focus on the legal status of institutions. Commercial banks are regulated differently from investment banks, which are regulated differently from insurance companies, and so on. Hedge funds are not regulated at all. Instead, regulation should be targeted on highly indebted, highly leveraged institutions, whatever their formal legal status. Debt can play an important positive role in the economy, but there can be much too much of a good thing. Excessive debt threatens stability. However, if there is less debt, less lending and less borrowing, there will be less spending. How are we to maintain demand while urging banks, firms and households to take fewer risks?

In the short run, only the Government can do the heavy lifting. Policies to maintain demand by cutting taxes—especially taxes on the poor, who have the great macro-economic benefit of spending every pound they get—and increasing government expenditure are vital if the economy is not to slide into depression. This is recognised around the world. In the medium term, demand must be driven by innovative industrial and commercial investment, changing the balance of the UK economy and winning markets at home and abroad. Government spending on infrastructure now will aid in this drive for competitiveness. A new pro-industry approach will focus on skills, on the exploitation of new technologies and on creativity, and there must be funding to do the job. That is the proper role of the financial sector.

This will have important consequences for the structure of the labour force. One of the negative outcomes of the growth of the City has been that so much talent has been sucked into financial services. Now the brilliant mathematicians and physicists, who have spent their time enhancing the complexities of financial engineering, must do some real engineering. We must ensure that they are supported and incentivised in the transition.

There is, however, a serious barrier to short-term economic recovery and sustained economic progress in the medium term. In a global economy, the success of all these policies—creating a stable financial sector, boosting demand in the face of recession, maintaining medium-term growth—depends on international co-operation and co-ordination. That is why the G20 meeting in London in April is so important.

In all areas of the economy new international economic relationships must be forged, backed by new international institutions. Here we are lucky because there is a map to guide us. The principles developed by the late Lord Keynes and embodied in post-war institutions hold good today, even though the actual application of those principles will be completely different. In the light of the bitter lessons of the financial instability of the 1930s, Lord Keynes sought to devise a system that would deliver stability and maintain the growth of demand.

To achieve the same today, the G20 must tackle three major problems. First, the serious international imbalances that saw the United States running ever larger balance-of-payments deficits with China, and hence accumulating ever larger indebtedness, were unsustainable and indeed were a major cause of our current woes. It must be accepted by all that running major balance-of-payments surpluses is a seriously destabilising policy for the world. Countries with persistent surpluses must accept measures that will reduce those surpluses, preferably by exchange-rate revaluation.

Second, national stimulus to demand in the face of the recession must be a common strategy. There must be no free-riders. If nations do not act in concert then those that do expand will be left holding the world's deficits—again, an unsustainable position that will undermine the whole recovery. Thirdly, as far as finance is concerned, international markets require international regulation, with rules not only agreed upon but adhered to and enforced both nationally and internationally.

In 1998, in the aftermath of the Asian financial crisis, it was this Government who persuaded the G7 to set up the Financial Stability Forum, the intergovernmental think tank for international financial regulation. Now the G20 will need to construct an operational counterpart to that forum that can monitor and co-ordinate measures implemented in individual jurisdictions. The Prime Minister has suggested that the IMF could fulfil that role but I am not convinced that this would be the best approach, since what is needed is an organisation that has a new sort of relationship with authorities in systemically relevant countries. The new authority must be able to tell the US Government when they are making mistakes, something the IMF is unlikely to do.

I am optimistic. In the face of the most serious economic and financial turmoil since the war, Governments are acting and learning. The determination to tackle short-term and medium-term problems is evident around the world, and our Government are part of that international consensus for action. The economy is not an immutable force that we can do nothing about. It is a set of social institutions devised by individuals, firms and Governments. We can fix it, and we will. I beg to move.

Annotations

C Villa
Posted on 6 Feb 2009 1:36 pm (Report this annotation)

We will not buy new cars till the owners of car manufacturing offer truly clean and affordable cars. Like us, millions. The whole system can go to he** The owners of car manufacturing have been making monumental profits during the last 40 years. They have the technology and the money to start changing their technology and produce the cars we are asking for. Still they continue to offer us the usual dirty, diesel/petrol consuming machines. When our old second hand car collapses, we'll get another old second hand machine. When the old cars are finished, we'll get a mule and a cart.

daniel pavon
Posted on 7 Feb 2009 6:34 pm

This annotation has been removed