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The government is showing a new readiness to cross an ideological Rubicon
It is hard not to despair at the gravity of our economic plight. The forecasts to be released this week are expected to confirm that Britain's output will not recover to 2008 levels until 2014, representing the deepest recession and slowest recovery since the 19th century and even that prediction may prove too optimistic. The money supply is barely growing; new credit advanced to small and medium-size entreprises (SMEs) is still falling. This should not be happening more than two years into recovery.
Some figures dramatise the grim picture. Business investment grew just 0.1% in the past three months. In the past six months, construction began on a mere 1,746 social homes – with zero starts in the north-west and 12 in the north-east. The £2.5bn business growth fund, created by the banks, has made only two investments – worth a total of £8m – since its launch in April. Only four companies have signed up for an enterprise capital fund to support the exports of SMEs. It is beyond pitiful. The early 1930s were a boom by comparison.
Yet no significant improvement is in prospect. The government's mounting desperation about the crisis its policies have wished on us is obvious; already changes are afoot that reveal a new readiness to cross an ideological Rubicon – that is, using the state to act. Last week, David Cameron and Nick Clegg launched a new-build indemnity scheme under which the government will underwrite a percentage of the loan, allowing buyers to have as little as 5% deposit – a first, even if the impact will be trivial. On Friday, Clegg announced a three-year, £1bn programme to alleviate youth unemployment, the centrepiece of which was a six-month wage subsidy for employers hiring young unemployed under 24.
They are small moves but in the right direction. The Conservatives are under intense pressure from their Lib Dem partners and the force of events is modifying their misguided belief that market economies should be left to their own devices. The private sector's problem is not government: it is lack of demand, existential risk, overstretched balance sheets and the embedded volatility of unconstrained markets. There is, and always has been, a co-dependence between the public and private sectors. The private sector needs the public sector to mitigate risk, plug the gaps left by its many mistakes, manage demand and ensure social stability and opportunity. In turn, the public sector needs the private sector's dynamism and readiness to experiment. But, having begun its change by subsidising wages and guaranteeing mortgages, the government now has to follow through. It has to think and act big.
It has to lift demand and address the business credit crisis and also lay the foundations for more innovation, a better capitalism and a 21st-century social contract. They are interconnected propositions – success in one will feed through to another. For example, banks say business won't borrow because of lack of demand; business says banks are too risk-averse. Both propositions are true; both have to be solved.
The means to break the logjam is at hand and the government is showing some movement, but again with too little conviction. What it will propose, it appears, is a £10bn loan underwriting programme for which it will charge a hefty insurance premium: however, the take-up, like its other schemes, will be trivial. The anxiety is to minimise exposure to the chance of assuming some real risk, but that is exactly what is needed. Instead, it should announce a generous multibillion-pound business loan purchase scheme using the funds created by the Bank of England's quantitative easing programme, so directly incentivising banks to make what would become very profitable lending. Because it is banks that have the relationships with tens of thousands of businesses, it is through them that new money can flow fastest. But banks have to see the prospect of profit in making loans that under current conditions will almost certainly go sour.
Here is how. The Treasury should offer to buy part of every new loan made to an SME as long as the originating bank accepts a small proportion of any loss and holds part of the loan itself to show its confidence in its lending decision. The Treasury should then merge these thousands of loan fractions into big bonds that it would indemnify, turning them into a security that the Bank of England – or private buyers – could buy.
In our paper, Credit Where It's Due, Lancaster's Professor Ken Peasnell and I estimate that this measure could lift SME lending by at least 10% a year, so that in 2013/14 the cumulative stimulus would represent up to £15bn a year. Banks can put up less capital, run less risk and access cheap finance. Triggering collective action by all banks and bringing forward investment by many SMEs will improve the economic climate, so the Treasury need not charge an insurance premium for its guarantee because the loan loss rate should be small – and high take-up at this stage in the cycle is highly desirable.
To ensure the loan loss rate will be low, the government needs simultaneously to boost demand. It should get serious about infrastructure spending. Pension funds will not invest directly in infrastructure, as the government hopes they will: it is too risky. But they would buy bonds issued by an infrastructure bank capitalised by the government. In its absence, the government should plug the gap, but that would mean breaking the taboo that it cannot and should not borrow. And, last, the government should slash employers' national insurance contributions until unemployment falls below 2 million, while cutting taxes on the low-paid.
The combination of these three measures – the loan purchase programme, infrastructure spending and national insurance/tax cuts for the low-paid – would be decisive. They would guarantee growth, lift business spirits and show our "lost generation" that we collectively cared.
Nor would I stop there. Britain should avert the risk of the euro collapsing by saying that, along with the rest of the G20, we will contribute to a European monetary fund, conditional on Germany making a hefty contribution and lifting its prohibition on the European Central Bank buying euro debt. A chance to lead in Europe and secure a full-throated economic recovery is in our hands. What it demands is nerve.