Sir Mervyn cannot bring himself to declare that the Bank was party to the gigantic intellectual mistake that led to the crisis
Sir Mervyn King, governor of the Bank of England, is by common consent formidably clever. Better to have him on your side than against, one might think – for which George Osborne, whom the governor has taken so protectively under his wing, must continually give thanks.
So any criticism of him has to be forensic because, like the curate's egg, Sir Mervyn is good in parts. For example, he is right to slate the City for talking a free-market game while being in receipt of the biggest bailout in history. And he was also right, in his Radio 4 lecture last week, to insist that banks must ringfence their commercial operations from the potential contagion of their investment banking arms.
But for all that, Sir Mervyn is a problem. The governor used the lecture to explain our economic predicament and to suggest what must be done to avoid a repeat. But in the process he alarmingly revealed how little he had learned – and how much he still has to recast the framework in which he thinks.
At first glance the governor seems tough on both himself and the Bank. In the run-up to the financial crisis, it should have shouted from the rooftops, he said, about how dangerous the situation was becoming, with banks becoming ever more stretched with less and less capital. But it didn't. Nor did it preach that the lessons of history had been forgotten, as it should have done, declared the governor. It did not warn that banks had grown excessively big and that light-touch regulation had failed.
But having acknowledged the omissions – and tried to excuse himself by noting that others were making the same mistakes and the Bank's responsibility for regulation had been taken away – he provided no answers.
For Sir Mervyn cannot bring himself to declare that the Bank was party to the gigantic intellectual mistake that led to the crisis. Worse, Sir Mervyn can make a reasonable claim to be one of the co-authors of the ideas that made him and others so blind to what was going on, and are still blind today.
It is now obvious that the Bank should have pressed for controls on the amount banks themselves were borrowing, on the proportions of loans that could be lent against property collateral (loan-to-value ratios) and even on the crazy system of pay and bonuses that encouraged such wild risk taking.
It should, as the governor said, have taken away the punchbowl as the financial party got going. But it is equally obvious that in today's circumstances the Bank and government now have to do the reverse: to induce banks to drink from that same punchbowl to get a party started. Our problem in 2012 is not preventing another financial crisis; it is recovering from this one.
Sir Mervyn can no more think today of direct intervention in the banking system, as lending now contracts and the economy faces years of stagnation, than he could in the 20 years before 2008 when bank lending rose to five times GDP. In a real sense he doesn't get the dynamics of capitalism, of risk or of finance – or of the proper role of the state in relation to them.
He doesn't have to look far. Arms races are a human response to uncertainty about a competitor's or enemy's intentions; you stockpile more weapons fearful that others are stockpiling even more. His own director of financial stability, Andrew Haldane, gave an intriguing speech in April describing the financial system's proclivity for such damaging boom/bust financial races.
Finance has three characteristics that make it especially prey to arms race effects. Banks depend on depositor confidence, and are especially vulnerable to "runs" (they can equally suffer from overconfidence). Second, in finance there is only one winner. And last, there are multiple and transparent league tables that make comparisons about pay and performance easy – so trying to outdo the next bank is straightforward.
Put all this together, argues Haldane, and you get wild arms races. In good times they are about lending and paying more and more. In bad times these races are about pulling in your horns, hoarding cash and competing to have even more highly secure and safe lending than the next bank. Thus there is a symmetrical obligation upon government and the central bank: to head off arms races in good times and bad by direct intervention in the financial system. In other words, to take away, or indeed introduce, the punchbowl.
Twenty years ago I wrote a pamphlet for the IPPR thinktank – Good Housekeeping: How to Manage Credit and Debt – in which I argued for a range of interventionist measures to head off credit booms or busts. They included a call for adjusting loan-to-value ratios over the economic cycle and a proposal to vary bank liquidity through adjusting reserve requirements.
The newly appointed chief economist of the Bank of England, Mervyn King, wrote a short private paper pointing out why I was wrong. Interest rates were all that was needed to control credit and the money supply. Contra-cyclical regulation of the type I wanted would inhibit banking efficiency and thus damage the wider economy, he argued. Financial markets were efficient, and failures and misallocation of resources could be induced by government regulation. Gordon Brown was to buy Mervyn's propositions hook, line and sinker.
In 2012 I rest my case – but the policy conclusions remain in bad times just as they do in good. Quantitative easing is now such a failure because it does nothing to get banks to drink from the punchbowl. To do that the state has to assume some risk at times like these. For example, we need public capital to support the risk in infrastructure lending, now contracting dramatically when it should rise. We need public guarantees of part (not all) of new lending to business, especially small and medium-sized business. We need flexibility in the conduct of fiscal policy when the economy is stagnating, otherwise the plans – and political capacity – to lower the deficit become incredible.
Sir Mervyn sets his face against such an approach, backing Osborne to the hilt. After Thursday's election results the Lib Dems risk being eliminated as a national political force – and the Conservative vote has nose-dived. More of the King/Osborne double act will shatter the Lib Dems for a generation, and fatally factionalise the Conservatives. Electorates don't understand the disputes of remote economic theory. But they do understand the results.