Economics: No pain, no gain

Damned if they do and damned if they don’t might be the popular verdict on
the activities of the financial services sector in recent years. When interest
rates were at historical lows, it supposedly encouraged a borrowing bonanza,
fuelling a housing boom and spending surge, resulting in record levels of
personal sector debt, equivalent today to 160% of earnings.

Now, however, it is payback time for lenders and borrowers. The credit crunch
has meant financial institutions retrenching from many of their traditional
activities as they try to shore up balance sheets, manage bad debts and rebuild
margins. As a result, the housing market is slowing at rates not seen since the
early 1990s, with prices falling and first-time buyers struggling to get a
mortgage. And, with higher debt servicing charges squeezing disposable incomes
and mortgage equity withdrawal tailing off, the next few months on the high
street are expected to be bleak.

So, the sector that was at the forefront of Britain’s impressive growth of
recent years is now thought to be adding to the downward pressure on the
economy. The timing of interest rate cuts is now seen to be more a reflection of
what is happening in financial markets than an indicator of the health of the
real economy. This is a new problem, uncharted territory, and it emphasises the
truth of the old maxim that ‘the past is not a good guide to the future’.
Several interesting points are raised by the UK’s current predicament.

More than previously – with the possible exception of oil prices – the credit
crunch highlights the increasingly global nature of economic events. There is at
present a lack of confidence in wholesale financial markets in the UK, markets
used by banks to raise funds over and above those they attract through their
retail networks. But since last summer, bank A has not been willing to lend to
bank B because of the uncertainty of what is in bank B’s portfolio. That
uncertainty relates to sub-prime loans made in the US, but which have since
found their way into the financial systems of most industrialised countries. It
is not a uniquely British problem, either.

Second – if it is not too self-serving – it shows how important banks are to
an economy. The UK can grow and prosper without car manufacturing capacity, with
its textile industry relocated in Asia and its coal mines closed. But if the
banking system stalls, the economy is in trouble.

Financial institutions in effect provide the plumbing that allows goods and
services to move around a system, that takes risks on investments and that
offers rewards for savings. Now, there is a need to unblock the pipes to get
things moving again.

Third, the present impasse shows the limited influence policy-makers have on
events. The key rate for bank-to-bank lending is three-month Libor, rather than
Bank rate, the benchmark for retail customers. Generally, there is barely a
cigarette paper between the two rates, but in the last three months of 2007, the
differential jumped to 1.15%. Having almost disappeared in January – suggesting
normal service was resuming – a gap has again emerged, of around 0.7% to 0.8%.

Confidence has again evaporated. Just because the MPC reduces Bank rate does
not mean the gap with Libor will close or even stay the same. Uncertain
financial institutions may not pass on Bank rate cuts to retail customers,
because they are still uncomfortable with the risk, or they prefer to rebuild
margins.

As the Bank of England Credit Conditions Survey for Q1 shows, there was a
reduction in credit available to both personal and corporate customers in the
three months to mid-March on the previous quarter, with further reductions
expected in the next three months. At the same time, the increase in spreads on
lending to both groups shows that what credit was available was getting more
expensive. This was also expected to continue in the coming months. For an
economy in which borrowing has underpinned growth, this will be a rude
awakening. The BoE is probably as concerned with banking system liquidity as it
is with interest rates, and this debate with the banks has been going on since
last autumn.

If all this sounds terribly negative, consider the following points. Will the
economy really be weaker if borrowers can no longer get 125% mortgages? Would it
be such a bad thing if lending criteria are brought more into line with the
borrowers’ ability to pay, and if the rates charged on lending reflect more
realistically the risks involved?

If the UK economy is to be rebalanced as the policy-makers keep telling us it
has to be, putting a tighter squeeze on consumption is an essential first step.
Painful though it may be for many people and businesses in the short-term, this
necessary correction may come to be regarded as a blessing in disguise.