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Bank of England was powerless in the face of excessive credit growth
Rationing is associated with the Second World War, austerity Britain in the late 1940s and early 1950s and, for those familiar with Moscow pre-Glasnost, the empty shelves of GUM, the Soviet Union's leading, but mostly empty, department store in the 1970s and 1980s. Rationing has, though, made a spectacular return. You won't see it in the shops, or online, or on the forecourts of used car dealers. In financial markets, though, it's all the rage.
In the good old days, before the advent of the credit crunch, financial markets were apparently driven by price alone. Interest rates told you something about the supply of, and demand for, capital. The higher rates were, the costlier it was for borrowers to raise funds (although, by the same token, the more attractive it was for lenders to supply funds). Central banks could supposedly control credit creation by acting purely on borrowers' demand for credit. So long as the central bank was able to set the price of credit via the policy rate, the quantity could easily be regulated by a forward-looking, independent and wise monetary authority which could second-guess the reaction of households and businesses to changes in policy rates.
That was the theory. The experience of recent years, though, suggests that, as is often the case in economics, the theory was just one too many steps removed from reality. While, for example, the Bank of England was steadily raising interest rates through much of this decade, these actions did little to constrain the growth of credit. For much of the time, higher policy rates were mostly associated with looser credit conditions.
This is, I admit, a perverse claim which, on initial inspection, seems to be at odds with much of the evidence. After all, during the period of rising policy rates, sterling strengthened more and more, implying a fall in import prices which, other things equal, would have kept inflation in check.
True enough, but short-term movements in inflation provide no clear indication of conditions in the credit markets. If you don't believe me, take a look at the US in the "Roaring Twenties", a period of very loose credit conditions accompanied for the most part by deflation. Have a glance at Japan's experience in the late 1980s, where all sorts of bubbly credit developments were accompanied by mostly well-behaved inflation.
Rationing provides the flipside to earlier years of excessive credit growth which, I'd argue, the Bank of England was simply unable to control. The evidence is compelling. The Bank of England raised policy rates, but mortgage rates didn't fully follow suit. Junk bond yields actually fell through much of the decade, despite the Bank's monetary entreaties. The quantity of household debt rose unusually rapidly. Most worryingly, the UK financial sector's balance sheet expanded extraordinarily quickly, as bundles and bundles of cheap credit were made available to free-spending households and companies.
Why, in an environment of rising interest rates, was credit so readily and cheaply available? The answer lies with the distorting effects of international capital flows and growing global imbalances.
Until recently, the US and UK balance of payments current account deficits got bigger and bigger year by year. Offsetting these rising deficits were ever-larger surpluses in China, Saudi Arabia and Russia, among others. Put another way, major industrialised countries were borrowing in ever-increasing amounts from high-saving emerging economies.
The emerging economies invested their savings in ultra-cautious products including, most obviously, US Treasuries. Treasury prices rose, pushing yields lower. Meanwhile, private sector investors were still reeling from the stock market crash in 2000 and 2001, and were on the hunt for investment opportunities which would provide higher returns than government bonds but lower risk than equities.
The UK's credit boom is directly linked to these investment preferences. Because UK short-term interest rates were higher than elsewhere, a direct result of attempts to rein in domestic inflation, international investors borrowed in low-yielding currencies such as yen and Swiss francs to invest in sterling exploiting so-called "carry-trades". Because the City of London had more expertise than most in creating new financial products, the UK became a centre of securitisation, with loans to both households and companies bundled up into bonds which were then sold to both domestic and foreign investors. And, as a result of a laissez-faire approach to regulation, policymakers were relatively relaxed about the resulting huge increase in both household debt and the financial sector's balance sheet.
During this period of plenty, the UK economy became increasingly unbalanced. Exporters were hit because capital inflows shoved the value of sterling skywards. The domestic economy flourished because, for any given level of policy rates, the supply of credit was bountiful.
We're now paying the bill for this earlier excess. Britain's ability to tap into global credit lines depended critically on trust in securitisation and confidence in the benefits of carry-trades. Both of these supports have now been kicked away. Sterling has, as a consequence, spiralled downwards, while the quantity of credit now being offered has collapsed.
Sterling's decline will make some contribution to rebalancing the economy – in current circumstances it's about the only conventional monetary weapon left – but the UK's ability to improve its share of world trade or to boost its exporters' profitability will have only limited benefits in a situation where world trade is in a state of collapse. Meanwhile, with base rates not too far away from zero, the domestic monetary problem is all-too-obvious. Even if the price of credit is incredibly low by historic standards, the available quantity of credit remains heavily rationed. Put simply, without carry trades, without securitisation and without the activities of foreign banks (who have headed back home, most obviously to Ireland and Iceland), there simply isn't the capacity to maintain lending at the overly-inflated volumes of a couple of years ago.
The UK recession, then, isn't entirely a home-grown affair. But nor is it the result of a chill wind blowing across from the other side of the Atlantic. It is, instead, the result of the complex interplay between domestic policy and global capital markets. Over recent years, Britain's policymakers have seen their capacity to influence economic outcomes diminish as Britain's economic development has become increasingly dependent on the waxing and waning of capital flows from abroad.
How should policymakers adjust to this complicated new world where changes in short-term interest rates do not lead to desired economic outcomes? One response would simply be to impose capital and exchange controls but, for Britain, that would be a disastrously retrograde step. Another would be to co-ordinate monetary and fiscal policy more closely, so that the economy could be cooled down without the need for higher interest rates, but that would threaten the independence of the Bank of England.
A more promising option would be to focus on a new credit policy tool to influence the supply of, rather than the demand for, credit. Thankfully, the Bank of England is already doing work in this area. It should be offered every encouragement because, without an influence on the supply of, rather than the demand for, credit the UK economy will remain too much at the mercy of the international elements.