The cautious approach to fixing banks will not work

By Martin Wolf
Published: June 30 2009 20:03 Financial Times

With one bound the banks are free, or so it seems. Already, the panic of the autumn of 2008 is fading. The period within which lessons can be learnt and changes made is closing. Yet without radical changes, another crisis is certain. It may not even be that long delayed.

In a recent speech, governor Elizabeth Duke of the Federal Reserve told an anecdote from just after the failure of Lehman Brothers last September. Ben Bernanke, chairman of the Federal Reserve, was asked: “Well, what if we don’t do anything?” To which he replied: “There will be no economy on Monday.” Instead, all institutions deemed systemically significant were saved, by shifting almost all of the risk on to taxpayers.

“Never again” might be too much to ask. But “not for a generation” is essential. Governments cannot afford an early repeat, financially, politically, perhaps morally: the lives of so many cannot soon be sacrificed to the whims of a foolish few.

Yet what has emerged after the crisis is, as I argued last week , an even worse financial system than the one with which we began. The survivors are an oligopoly of “too-big-and-interconnected-to-fail” financial behemoths. They are the winners not because they are necessarily the best businesses, but because they are the best supported. It takes no imagination to realise what these institutions might now do, given the incentives for risk-taking.

So what is to be done? The characteristic, but futile, response is to move the regulatory deckchairs on the deck of the Titanic. Recent proposals from the US Treasury fall partly into this category. But the financial system had to be rescued from its own mismanagement of risk. This is not going to be changed by external supervision. It is going to be changed only by fixing incentives.

The starting point has to be with “too big to fail”. We need a credible system for winding up even huge financial institutions. The most attractive proposals are for “good banks”, in which unsecured creditors become shareholders. That would be easier if, as President Barack Obama has proposed, and Mervyn King, governor of the Bank of England, has argued, a regulated institution has to produce a plan for an orderly wind-down of its activities.

Yet bank failures are like buses: you do not see one for hours and then a fleet arrives together. The authorities cannot make a credible promise that they would be prepared to put all affected institutions through bankruptcy in a systemic crisis. This would be a recipe for still-greater panics. “Too big and interconnected to fail” is a reality. It is so, because, as Andrew Haldane of the Bank of England pointed out in a recent speech, the financial system is an increasingly tight network.*

My colleague John Kay has argued that the right response is to create “narrow banks”, which are perfectly safe, leaving the rest of the financial system to go on its merry way, subject to a then-plausible threat of bankruptcy. I find this idea both attractive and unpersuasive. The attraction seems evident. It is unpersuasive in part because it is so hard to agree on what narrow banks should do. It is also unpersuasive because the narrower the banks are made to be, the more vital is the role of the rest of the financial system and so the less plausible it is that governments would let it collapse.

If institutions are too big and interconnected to fail, and no neat structural solution can be identified, alternatives must be found: much higher capital requirements and greater attention to liquidity are the obvious ones. At present, big financial institutions operate with next to no capital: in the US, the median leverage ratio of commercial banks was 35 to 1 in 2007; in Europe, it was 45 to 1 (see chart). As I noted last week, this makes it rational for shareholders to “go for broke”, with the results we have seen. Allowing institutions to be operated in the interests of shareholders, who supply just 3 per cent of their loanable funds, is insane. Trying to align the interests of management with those of shareholders is then even crazier. With their current capital structure, big financial institutions are a licence to gamble taxpayers’ money.


So how much capital makes sense for systemically significant institutions? “Much more than today” is the answer. Moreover, the required capital must also not be risk-weighted on the basis of banks’ models, which are not to be trusted. Shareholders’ funds should make up a minimum of 10 per cent of capital. In the US, it used to be far higher.

Higher capital is, in addition, a good way to internalise the negative “externalities” – more precisely, risks – created by one institution for the entire system. Ideally, therefore, the required capital should be correlated with the systemic significance of institutions, as the excellent new annual report from the Bank for International Settlements argues. Moreover, the requirement should be set against all activities, on the basis of fully consolidated accounts.

Within a far better capitalised financial system, it would also be relatively easy to operate a “macroprudential” regime, with the required capital rising during booms and falling during busts. Again, the bigger the stake of shareholders, the less one would worry if the rewards of managers were aligned with them. Even so, regulators have to have some sort of control on the incentives of management, as long as taxpayers bear residual risk.

Two difficulties remain: the transition; and regulatory arbitrage.

On the former, a demand for much higher capital ratios today would imperil the recovery. The answer is a lengthy transition, perhaps of as much as a decade. On the latter, it is evident that the so-called “shadow banking” system cannot be allowed to operate outside capital constraints if entities within it are likely to be systemically significant, as proved to be the case for money market funds. Moreover, capital ratios would have to be imposed by all significant countries. But the US is powerful enough to force movement in that direction by insisting that any foreign bank operating within it must be appropriately capitalised.

In sum, deleveraging is the right starting point for a healthier financial system. This would work best if we also eliminated today’s huge fiscal incentives for borrowing.

It is cautious incrementalism, not radicalism, that is now the risky option. Where should such radicalism start? The answer is clear: it is the incentives, stupid.

Cutting question - Consumer Boom?

By Andrew Bounds and Chris Giles

Published: June 16 2009 03:00 Financial Times p 7

As Britain's recession bit over the winter, the country became obsessed with finding someone or something to blame. Greedy bankers, addicted to taking risks and paying themselves lavish sums, took much of the flak, as did hapless financial regulators who failed to react to the danger signs.

But fingers were also pointed at ordinary households: Britons had become hooked on material consumption, fuelled by debt and rising house prices. People flocked to the "Together" range of mortgages from Northern Rock, which offered loans of up to 125 per cent of a property's value until the lender ignominiously failed. London's house prices and luxury shopping boomed on the back of big City bonuses. It was unsustainable and, as economists like to say, things that are unsustainable do not last.

But as Britain starts to enjoy its new sport of spotting the green shoots of economic growth sprout up (and seeing whether they will wither), was it all the standard story of consumer boom followed by inevitable comeuppance? Once you get past the anecdotes, the evidence is against that.

One good place to start is a comparison with the 1980s, when no one doubts Britain's consumers went shopping crazy. As a share of gross domestic product, household consumption rose by almost 2 percentage points, with the big boom between 1985 and 1988, when it reached 60.5 per cent of GDP. In comparison, for all the talk of shop-till-you-drop consumers bashing their credit cards, consumption this decade has fallen as a share of GDP by 1.3 points, with declines even during the supposed consumer boom years of 2006-07.

In this decade, the price of imports, particularly from China, has gone down - so people can feel happier about falling consumption. But this underscores the data findings that households did not go on some dreadful borrowing and spending binge. Based on this and other evidence, economists such as Ben Broadbent of Goldman Sachs become agitated, saying: "I just don't understand why people persist in saying there was a consumption boom - there just wasn't."

But the popular belief, also stoked by many economists and officials, remains that consumption has boomed and that is the prime cause of unsustainability in the economy. The rise in household debt to 160 per cent of disposable income, from 100 per cent in 2000, has to unwind, says Andrew Bridgden of Fathom Financial Consulting, and if that happened gradually, "then growth in consumption would be subdued, perhaps close to zero, for the next 10 years".

The International Monetary Fund last month sang from the same hymn sheet in its annual survey of the British economy. "The high level of household indebtedness constrains the pace of economic recovery," it concluded, at the same time fretting about weaknesses in banks.

Mervyn King, the Bank of England governor, came close to the same interpretation of the feebleness of household finances and the resulting sluggish outlook when presenting the central bank's latest inflation report. "In the light of the state of balance sheets, especially in the financial sector, the [Monetary Policy] Committee judges that the risks are weighted towards a relatively slow and protracted recovery," he said.

The dispute about the fragility of household finances stems from a legitimate fear, underscored by a plunging household savings rate in 2006-07, that households were living well beyond their means. The savings rate even briefly turned negative at the start of 2008, fuelling concerns about overconsumption among households and the inevitable retrenchment to come.

But a closer look shows the main reason for the savings drop appears to be that as inflation rose over that period, so did households' bills and spending. Consumers did not cut other items much, sensing the rise in prices was temporary - which turned out to be the case. Subsequently, incomes rose faster than expenditure, bringing the savings ratio back to 4.8 per cent, a level no different from a decade earlier. Though households could decide to retrench, the evidence that they will is so far rather thin.

But as so often with aggregate data, the real behavioural response of households is difficult to infer from the figures because so many things are going on. This is where microeconomic evidence can help - and this year, evidence has accumulated to suggest that there was indeed no housing-fuelled consumption boom.

John Gathergood and Richard Disney of Nottingham University compared the spending and saving behaviour of the same households over time and found, first, that those renting properties were just as likely to reduce their saving when house prices were booming as home owners were. This result has been seen repeatedly in large-scale economic studies of the UK and is a real challenge to the consumption boom protagonists. Why would renters spend more and save less when house prices rise, since their chances of getting on to the housing ladder had just grown worse?

The two researchers went further and added household expectations of their future incomes to their equations. This they found to be the most important determinant of active decisions to save. Renters, it transpired, saved less alongside homeowners because both groups were optimistic about their future incomes.

Looking at similar data across the Atlantic, the two could also spot a difference between British households, whose upbeat income expectations made them shun saving, and US households, who did respond aggressively to higher house prices.

If there is almost no evidence that consumption boomed this decade in Britain as a result of house price appreciation, why did household debt rise so explosively?

There is no disagreement that high house prices are related to this increase in debt, but a fierce disagreement persists between those who think loose lending criteria forced house prices higher and those who believe, as Mr King does, that high house prices led to higher debt because those buying a home needed a bigger mortgage than the people selling - as the vendors enjoyed capital gains from previous house price rises. While both arguments have merit, the important point is that debt and house prices went together, not debt and consumption.

Then, if consumption is not the obviously unsustainable element, where should the spotlight fall? Government spending on goods and services is the short answer. Health, education, defence and law and order spending (including capital expenditure) grew extremely rapidly from 2000, when all this accounted for 20 per cent of GDP, to the 24.4 per cent it reached in 2008. Although financed by borrowing, this rise appeared under control until the recession hit, because tax revenues were strong, particularly corporation tax paid by the risk-taking financial sector. Again, this was the reverse of the 1980s.

The public spending bonanza, financed by erratic financial sector profits, was clearly unsustainable. With tax revenues slashed by the recession and borrowing set to rise to £175bn ($286bn, €207bn) or 12.5 per cent of GDP, this level of government consumption will not be able to continue. The big story of the next decade will be government retrenchment and deficit reduction.

So what does that mean for the UK economy? As ever in economics, there is good news and bad news. The good news is that the absence of a boom over the past decade implies that a consumer retrenchment is far from a certainty, even with falling house prices. As in the past, incomes - and expectations of income growth - are more likely to determine household consumption than household finances and debt are.

Sterling's 20 per cent fall since November 2007 raises the competitiveness of the UK and should allow net exports and business investment to contribute significantly to growth, replacing government spending. Monetary policy is likely to remain very loose, to encourage demand as the government consolidates the budget. This is a reasonable expectation, says Malcolm Barr of JPMorgan, though it is impossible to know in advance "where is growth coming from".

But the bad news is that the recession has destroyed some of Britain's productive capacity forever - 5 per cent is the Treasury's estimate. Charlie Bean, the Bank of England's deputy governor, adds that the fragility of banks will hit working capital, corporate investment and research and development, so limiting potential growth, while unemployment reduces the skills of many employees.

Moreover, continued household consumption at today's level cannot be taken for granted. Households may find their income growth in the years ahead disappointing, especially as taxes and unemployment rise.

There is also the big unknown global element, which is whether the Asian countries that run big surpluses will put more effort into consuming at home rather than saving abroad. Such a shift would raise global real interest rates and make consumer debt feel more onerous.

Although what is not known outweighs the certainties, the outlook is not as bleak, at least for households, as the simple story of excess followed by penitence. Britain is often a miniversion of the US - but its unsustainable expansion of the past decade was very different.

Do not adjust your data set

One of the problems in determining the degree of any surge in household consumption is that the answer depends on which bit of the national accounts you use.

Gross domestic product - the value of goods and services produced in the economy each year - can be broken down into contributions from household consumption, investment, government spending, and the balance between exports and imports. This decomposition can also be adjusted for the inflation of each component part.

If no inflation adjustment is used, there was no consumer boom this decade. Household consumption fell from 63.5 per cent of GDP at the start of 2000 to 61.4 per cent in the second quarter of 2008, just as the recession began.

But after standardising everything at 2003 prices, the official figures show consumption rising from 61.1 per cent to 62.5 per cent of GDP over the same period.

Over long periods the nominal, or unadjusted, figures are preferable because they are easier to measure and they quantify what households actually spent, not the rather more nebulous concept of what their spending would have been had they bought the same goods and services but at 2003 prices.

Leeds

From mills to tills: an industrial centre turned shopping mecca

Few institutions epitomised the boom and bust of Britain's economic "miracle" more than Leeds United.

The Yorkshire soccer club, whose rugged style won league titles in 1969, 1974 and 1992, transformed itself into a leisure brand listed on the stock market and boasting a team full of young talent. By 2001 it had reached the semi-finals of the European Champions League. Then its debt caught up with it.

Owing £79m, it began a fire sale of players. Peter Ridsdale, chairman, left in 2003 but the shake-up could not stave off bankruptcy - or relegation. "We lived the dream," he said. The nightmare of a third season in the third tier of English soccer continues.

Could the city, which has undergone a similarly stellar transformation, suffer the same fate?

Regenerated after the collapse of the clothing industry in the 1970s, its centre is almost unrecognisable from the days when Montague Burton ran the largest clothing factory in Europe there. With engineering and textiles in decline, Leeds fell back on its other strength: finance. Yorkshire was the home of the building society movement and had a big legal sector. The city rediscovered a taste for shopping evident in the graceful but neglected Victorian arcades. Nothing did more to change its image than the opening of the first branch outside London of Harvey Nichols, the upmarket department store,in 1996.

In a decade from 1991 the number of bars and cafés doubled, with nightclubs and restaurants not far behind, as the leisure economy came to life. Up to £4bn has been ploughed into shops, apartments and offices in a centre once dominated by warehouses and mills.

That may reflect an unsustainable consumer binge, or it may just mark Britain's conversion to continental- style café culture. Since 1999 Leeds, with a population of 750,000, has added 31,600 net new jobs, a rise of almost 10 per cent. Yet a large amount have been in public services, and almost all the rest in finance and business services, which each account for one-quarter of the working population. The council believes it will be 2015 before employment returns to 2007 levels and is reducing its own staff by 450.

Civic leaders believe the financial goose will lay golden eggs again. There is still plenty of untapped wealth around: SG Hambros, the private bank, opened an office in the city only in March.

Howard Kew, chief executive of the Leeds Financial Services Initiative, points to the diversity of the sector, which includes asset management, call centres and retail banking. He also notes a tradition of innovation. First Direct, the first telephone bank, set up there in 1989. The recession could even help, as costs in Leeds are one-third lower than London, he adds.

Martin Allison, dean of Leeds Metropolitan University Business School, accepts the city has "suffered a systemic shock". But, he says, "it has had them before. Thirty years ago we were wondering what would come after textiles".

Andrew Bounds

France-UK Frost

Froid sur les relations franco-britanniques
LE MONDE | 09.02.09 | 15h13

La lune de miel entre Paris et Londres est terminée. Nicolas Sarkozy y a mis un terme, jeudi 5 février, en critiquant la politique économique de Gordon Brown, qu'il avait pourtant saluée à de nombreuses reprises cet automne. Son "amitié" pour le premier ministre britannique, sa "confiance" et son "estime" ont laissé place à un certain mépris, que le 10 Downing Street n'a que modérément apprécié.

"Franchement, quand on voit la situation aux Etats-Unis et au Royaume-Uni, on n'a pas envie de leur ressembler", a lancé M. Sarkozy. Au Royaume-Uni, la baisse de la TVA de 17,5 % à 15 % au 1er décembre n'a "amené absolument aucun progrès", a-t-il poursuivi. Mais, a-t-il précisé, "si les Anglais ont fait ça, c'est parce qu'ils n'ont plus d'industrie, à la différence de la France. L'Angleterre, il y a vingt-cinq ans, a fait le choix des services et notamment des services financiers".

"L'Elysée nous a contactés pour nous assurer que ces commentaires ne visaient pas à critiquer la politique économique du Royaume-Uni. Ce qui est gentil", a ironisé le service de presse de M. Brown. L'équipe du premier ministre a précisé que, contrairement aux allégations du président de la République, l'industrie britannique n'a rien à envier à sa concurrente hexagonale, comme en atteste le dernier chiffre disponible de la Banque mondiale : en 2006, l'industrie représentait 24 % de l'économie britannique et 21 % de la richesse nationale française.

Pour M. Brown, qui appelle à une coordination des politiques économiques alors qu'une réunion du G20 doit se tenir à Londres en avril, la sortie de M. Sarkozy tombe mal. D'autant qu'elle succède à d'autres. Wouter Bos, le ministre néerlandais des finances, a jugé la semaine dernière qu'une baisse de TVA "n'était pas avisée".

Virginie Malingre
Article paru dans l'édition du 10.02.09

Problems with Public-Private Partnerships

Public-privé, des ratés en série, par Virginie Malingre
LE MONDE | 09.02.09 | 13h46 • Mis à jour le 09.02.09 | 13h46


Uu jobcenter de mon quartier, quand j'ai rempli le dossier pour obtenir un "national insurance number", nécessaire pour des formalités administratives qui n'ont pas besoin d'être détaillées ici, l'employé chargé de mon cas a décidé que je cherchais "activement un travail". "Vous travaillez à la maison, votre employeur est en France. C'est compliqué. Après tout, ce que vous voulez, c'est votre "national insurance number". De toute façon, personne ne vérifiera", m'a-t-il expliqué. Je me suis imaginée aux allocations familiales en France, demandant un numéro d'allocataire. Et là, c'est sûr, on m'aurait gardé le temps nécessaire plutôt que de me faire mentir.

"C'est une histoire typiquement britannique, m'assure Patrick Dunleavy, professeur à la London School of Economics, spécialiste du service public. La personne qui vous a reçue doit traiter un certain nombre de dossiers par jour." Et son salaire dépend de sa performance. Le service public britannique s'est mis aux méthodes du privé avec zèle. Il se donne des objectifs aussi bien pour remplir ses lits d'hôpital que pour faire arriver ses trains à l'heure. Et distribue des bonus aux bons élèves.

"Après tout, ce que vous vouliez, c'était votre "national insurance number". Il a satisfait tout le monde, vous et son patron", conclut en riant M. Dunleavy. En l'occurrence, personne ne pâtira de cette fausse déclaration, si ce n'est les statistiques nationales, qui vont me comptabiliser comme chômeuse. Mais quand le secrétaire d'Etat à l'immigration, Phil Woolas, annonce, la semaine dernière, que ses services ont perdu 17 000 dossiers de réfugiés demandant l'asile - ils se sont évaporés entre deux bureaux -, on imagine le désarroi des individus concernés, dont certains attendent depuis plus de dix ans une décision.

Il ne se passe pas une semaine sans que la presse relate un bug de l'administration, aux conséquences plus ou moins dévastatrices. Pourtant, sous l'impulsion de Tony Blair, le secteur public s'est étoffé : il emploie aujourd'hui 5,8 millions de personnes, soit 20 % des salariés du pays, et les salaires y sont supérieurs à ceux du privé. Mais la City a longtemps aspiré les talents britanniques. Et les réformes que les gouvernements successifs ont menées depuis vingt ans, si elles ont amélioré l'efficacité des services publics, ont parfois été contre-productives.

Ainsi la fragmentation des tâches, qui devait permettre de lutter contre une bureaucratie excessive, s'est retournée contre ses concepteurs. L'affaire Baby P. - cet enfant mort début novembre sous les coups de ses parents - est de ce point de vue fort instructive. Soixante personnes de différents services publics (santé, police, école, assistance sociale...) avaient eu affaire à la famille sans qu'à aucun moment ces gens ne se parlent.

Fin novembre 2008, l'Ofsted (Office for Standards in Education, Children's Services and Skills), responsable des services d'inspection, dévoile dans un rapport accablant que quatre enfants meurent chaque semaine en Angleterre, comme Baby P., de violences parentales et de négligences des services sociaux. Quelques jours plus tard, le ministère de l'éducation et des familles, qui n'a pas supervisé le travail, corrige : le bon chiffre n'était pas 4 mais 1...

En France, pointe M. Dunleavy, "vous faites encore les choses à l'ancienne. Vous vérifiez quatre fois une information avant de la publier". Indéniablement, jamais Bercy n'aurait mis sur son site Web la mauvaise version de son projet de budget, comme l'a fait le Trésor fin novembre. Version qui a permis au pays d'apprendre que le gouvernement avait envisagé d'augmenter la TVA en 2011, après les prochaines élections.

Sir Digby Jones, ancien secrétaire d'Etat au commerce qui a démissionné en octobre, juge que Whitehall pourrait fonctionner avec "moitié moins de fonctionnaires". L'homme est connu pour ses sorties intempestives. Mais il est vrai que le secteur public britannique multiplie les ratés. Pour autant, quand le privé s'en mêle - ce qui se fait de plus en plus -, le résultat n'est pas concluant. Ainsi, juste avant Noël, 100 000 fonctionnaires ont appris qu'ils avaient reçu pendant trente ans une retraite trop élevée. Et qu'ils verraient son montant diminuer pour compenser le trop-perçu de 140 millions de livres. Tout ça parce que l'entreprise Xafinity, qui s'occupe d'une partie des retraites des fonctionnaires du National Health Service et de l'armée, s'est trompée dans ses calculs pendant trois décennies !

Là aussi, juge M. Dunleavy, "c'est typique. On demande à ces sous-traitants d'être le moins chers possible. Et en même temps, l'administration perd son expertise sur ces sujets qui sont externalisés". Et s'avère incapable de contrôler. C'est comme ça que, en novembre 2007, le fisc a laissé partir dans la nature les données fiscales de 25 millions de contribuables. La Cour des comptes lui avait juste demandé 20 000 dossiers anonymes. Mais personne au Trésor n'était capable de transférer ces données. Il a du coup été fait appel à un prestataire extérieur qui, pour réduire les coûts, est allé au plus simple : copier sur un CD tous les dossiers sans prendre la peine d'enlever les données confidentielles, et l'envoyer par la poste. Le courrier n'était pas recommandé - trop cher sans doute - et s'est perdu...

Courriel : malingre@lemonde.fr.

Wreckage of UK Economic Policy

What can Cameron do?
Ross McKibbin

LRB 23 October 2008

In 1931, as the European banking system seemed to be collapsing, the Austrian economist Joseph Schumpeter observed that people felt the ground giving way beneath them, and not merely those with bank accounts. Many in Britain and America must be experiencing similar tremors now. Yet, in Britain at least, there are huge differences between 1931 and today. The 1931 crisis had profound political consequences – it almost wrecked the Labour Party and established the extraordinary hegemony of Stanley Baldwin, Neville Chamberlain and the Conservative Party – but it was a balance-of-payments crisis that was resolved the moment Britain went off the gold standard and devalued the pound. Almost uniquely among major economies, Britain didn’t experience a run on the banks or a threat to people’s savings. No high street bank collapsed or was likely to. In so far as there was a nervous shifting of money it was from the banks to the building societies, whose golden age it introduced.

The stability of 1931 was based on large, conservative institutions – the Midland Bank (now HSBC) was the biggest bank in the world. Unlike so many of the American banks which collapsed, British banks were not dependent on the savings of rural and small-town communities (whose incomes had begun to fall even before Wall Street ‘crashed’). Nor, unlike the great German banks, were they large investors in perilously unprofitable industries. They were cautious organisations run by cautious men. The building societies were exactly that, societies for building: building houses in local communities to which many were tied. Nearly all were ‘mutual’: ‘owned’ by their depositors, they were products, like the co-operative societies, of the 19th-century tradition of financial mutuality. They were not investment or commercial banks; and did not want to be.

Again, the London Stock Exchange, unlike Wall Street, wasn’t a site of crazy speculation. There was less loose money sloshing around with no other profitable outlet; a stiff tax was levied on all Stock Exchange transactions; and the culture was different. The members of the predominantly Conservative governments of the 1930s were not wholehearted admirers of the City. They imposed exchange controls on capital exports and they believed in a ‘managed’ currency. This reduced the authority of the City banks that had been so influential in the 1920s and before the First World War. Free trade was abandoned: Britain became a protected and cartelised economy. These governments were often suspicious of the state and believed in balanced budgets, but even so they nationalised mining royalties, brought the national grid under public control and established Imperial Airways (the distant precursor of BA) as a state monopoly. They believed in capitalism as a system of private ownership, a system of social and economic virtue, but not in the piratical capitalism of the United States. The Conservative Party of the 1940s was not seriously hostile to the nationalisation of the mines and railways, or of the Bank of England.

How things have changed. That kind of Conservatism is (or was) one with Nineveh and Tyre. We are faced with the possibility of a Conservative government in less than two years’ time led by men who have hitherto represented the purest form of freebooter capitalism. Despite a couple of brazen attempts by George Osborne to pretend that the banking crisis has nothing to do with them, all its ingredients, to the extent that they are home-grown, were cooked up by the Tory Party – mostly under Thatcher. The first was the abolition of exchange controls, which had the effect of strengthening the City and its institutions at the expense of other sections of the economy, as well as permitting the uninhibited export of capital regardless of what it did to British economic and financial systems. The second was to allow the value of the pound to rise considerably, rendering much of British manufacturing uncompetitive. This led not only to the elimination of hundreds of thousands of jobs but to a ‘rebalancing’ of the economy in favour of the financial and service sectors – which the country’s elites convinced themselves was the way of the future. It also had long-term consequences for the current account that were hardly less damaging. The third was the ‘Big Bang’ and the process by which the City and the banking system were effectively deregulated.

If you wanted a ‘competitive’ and risk-happy City, as the Conservative government did, then getting rid of all the understandings and conventions that regulated the old City was entirely proper. The Big Bang undoubtedly reinforced the City’s international standing; but it encouraged ecstatic risk-taking everywhere – often via financial devices themselves intended to spread risk. It also encouraged, as in 1920s America, huge inflows of loose money that were hard to control and were usually seeking speculative returns. The Big Bang initiated the process by which the old merchant banks, still largely home-owned, passed into foreign ownership or simply disappeared. The result, whatever the intention, has been to make the British largely (and almost uniquely) indifferent both to who owns the country’s assets and to the purpose for which they are owned. (Since these assets had to be sold to cover ever widening current account deficits this is probably a mere quibble.) The inevitable accompaniment to the Big Bang was the deregulatory legislation of the 1990s which, among other things, allowed the mutual building societies to ‘demutualise’ and become banks.

Finally, and most important, the Conservative governments began the politicisation of British housing and its manipulation for electoral reasons. The desirability of owning one’s house has a long history in all English-speaking countries and there are good social arguments for private ownership. But there is a thin line between social desirability and political calculation, and Thatcher crossed it with complete insouciance. The mandatory sale of council housing was pushed through not for social reasons (though many defended it on those grounds) but as a way of re-engineering the electorate. When Conservatives spoke, as they often did, of a ‘property-owning democracy’, what they had in mind was an owner-occupying, Tory-voting democracy. Thus the councils whose houses were compulsorily sold were not allowed to spend the proceeds on new social housing, since that would create more Labour voters. New housing was almost always privately built – i.e. rationed. Since demand could never be met, owner-occupiers achieved an effortless rise in asset-wealth and privately built housing was increasingly used as security for consumption on credit. Again, that was its purpose. Although the rhetoric of Thatcherism was ‘productionist’ – thrift, hard work and so on – what it actually stood for was private consumption.

The housing boom of the late 1980s, ending, as it was bound to do, in the recession of 1990-91, eventually did for the Conservative government. In their criticisms of Labour’s ‘credit bubble’, Cameron and Osborne are right only to the extent that Labour further refined the politicisation of housing and carried it to its logical electoral conclusion. But there is no evidence that the Tories would have acted differently. Labour didn’t invent the credit bubble.

The banking crisis has understandably caught the Conservatives on the hop, and Cameron’s responses have been pretty incoherent. Much of what he recommended with confidence even a few weeks ago now sounds dated – as he knows. Fundamentally, he is trying to adjust Thatcherism to inappropriate political and economic circumstances. Thus he wants light regulation; he is opposed to forced nationalisation of financial institutions; he wishes somehow or other to cut taxes; he still believes in the overriding efficacy of the market as against the state; he is a man whose sympathies lie wholly with finance and financial institutions – probably inevitable in someone whose experience of life outside Parliament was a brief stint in a PR firm. He has, however, committed the Conservative Party to Labour’s current spending plans; he has reluctantly admitted that nationalisation of banks could be defensible (the sight of savers struggling to open accounts in Northern Rock must have shaken the faith of every committed free-marketeer); he has conceded that taxes might have to rise given the ‘mess’ his party will certainly inherit. In other words, he is all at sea. The banking crisis has undermined the whole edifice of Tory policy, which was founded on high levels of public expenditure plus a deregulated economy – i.e. exactly the same assumptions as New Labour’s, but tweaked in an even more free-marketish way.

The events of the last few days, however, have driven him far from free-market triumphalism. In fact, he has had little option but to support the public recapitalisation of the banks. The banks themselves want it and nothing else seems likely to restore the money markets or the mental balance of increasingly irrational stock traders. He has done this with reasonable aplomb; even trying to snatch some moral credit by appearing as the scourge of the money-lenders; something the City probably won’t forget. But we don’t know whether this is merely a tactical switch – to be abandoned when the good times return – or an expression of genuine doubt about his political inheritance.

In either case Cameron needs to accept that Thatcherite Conservatism is not the only form of Conservatism, and doesn’t have a unique political legitimacy. What is the function of the Conservative Party? It is to defend inequality: to make acceptable the social and economic unfairness inherent in a predominantly capitalist economy; to preserve the interests and privileges of social elites. But historically it has not been committed to a particular strategy to fulfil these aims. Thatcher appears to have thought that she was the first ‘proper’ Tory prime minister since Chamberlain. But Chamberlain was not a proto-Thatcherite, and the predominant Conservatism of the last thirty years has been unlike any other in the history of the party. As its behaviour in the 1930s suggests, the party has always been prepared to allow an active role to the state if circumstances required. It has not always given primacy to the unfettered market: indeed, it has hardly ever done so. And it hasn’t always been the party of banking and finance – and to the extent that it has been, it was in its role as the party of property rather than of finance. In the past, powerful forces within the party have aimed to divorce it from finance. Joseph Chamberlain’s campaign for protection before the First World War had precisely this intention; by 1914 the protectionists had won control of the party – and they kept it in the interwar years. Baldwin and Neville Chamberlain were products of that campaign. In Chamberlain’s case it simply ran in the family.

The Tories have had recourse to many specious slogans in the defence of inequality. One was ‘fairness’. Believing that Conservatism actually stood for fairness was doubtless naive on the electorate’s part, but it wasn’t wholly absurd. Until recently the party was reluctant to be seen sanctioning displays of conspicuous unearned wealth, but the difficulty with the economics it has espoused in the last thirty years is that unfairness and the display of conspicuous unearned wealth are intrinsic to it. That is its point. And this is what landed the party in so much trouble in the 1990s. There are no doubt many explanations for the debacle of 1997, but the deliberate abandonment of ‘fairness’ and the open cultivation of unearned wealth was one. For a time Cameron could get away with being in a muddle. That he is not Labour is his strong suit, just as not being Conservative was Blair’s in 1997. But as he gets closer to the election and, even more, if he wins it, muddle will become increasingly disabling. The policies to which he is naturally drawn will almost certainly be discredited and in any case won’t work. If, on the other hand, he comes to see that the party has other traditions, less heretical than neo-Thatcherism, he is unlikely to lose support among the electorate or his own party membership. If he doesn’t, he risks either losing the next election or leading a government even more unsuccessful than the present one.

Events of the last year or so – certainly since the run on Northern Rock – have imposed several almost inescapable obligations on any responsible government. The first is the restoration of the regulatory systems that were set up in most Western countries just before or just after the Second World War. Everything suggests that light regulation or self-regulation of financial institutions never works. In the General Theory, Keynes said he expected the state increasingly to determine the patterns of investment because the state, unlike everyone else, can take the long view. Keynes went further than we would want to go, but it is surely correct that among economic actors the state is best placed to arbitrate between differing and often antithetical economic interests and best able to regulate financial systems dominated by short-term decisions. What has happened in Britain and America is that the state has abdicated its responsibilities to such agents as the Financial Services Authority, whose regulatory touch has indeed been light. The question is how much of the regulatory regime can be re-established. Demutualised mortgage lenders can be remutualised only with difficulty, but they should at least be subject to adequate regulation, whether by the Bank of England or the FSA. Even if it is unlikely that the present political class will entirely restore the credit discipline of the 1950s, when governments controlled access to credit by fiat, something like it seems unavoidable.

The second inescapable obligation is the return of housing to its proper function: as providing places to live in rather than to speculate on. The relationship of housing to politics in both Britain and the United States is not fully understood even by those who transformed it. They don’t understand it because that would require confronting awkward facts about Anglo-American democracy. Fundamentally, private housing has become a compensation for the increasingly gross maldistribution of income. Inadequate incomes mean that large numbers of people don’t have access to the style of life that has always been the ultimate justification of neoliberalism and to which, reasonably enough, they now believe they have a right. What does give them access to it (in the short term) is credit. But credit has to be secured, and that’s what housing does. However, it works only if house prices keep rising and people have enough income to repay debt. When prices stop going up and people can no longer repay what they owe, the financial system begins to disintegrate. This is what has happened; and it has happened because we have replaced something like social democracy with credit democracy, or universal access to credit, and credit is a thoroughly inadequate substitute because sooner or later it has to be repaid. Which means that people’s incomes have to be sufficient to repay it, and in many cases they aren’t. What we have put in place is a dynamically destructive cycle. The number of houses is rationed in order to force up prices; people buy houses in order to secure credit on the strength of those prices; this encourages a heady belief in perpetual profit and thus both risky lending and risky borrowing; this renders the banking system unstable; and lending both to individuals and among banks then collapses. Such a cycle involves a paradox. Since these credit democracies still hold elections, governments are forced to underwrite savers at the expense of creditors and stockholders. And if savers are also small shareholders, as many are, the price they pay for protecting their deposits is the devaluation of their shares. This is absolutely not what was originally intended. The rationing of house building has one other consequence: it means that many cannot acquire somewhere adequate to live.

As a way out of this, stricter regulation, though necessary, is not enough. Governments must restore house building to something like postwar levels. When Richard Crossman was housing minister in the 1960s, some 400,000 houses were built every year, most of them council houses. In the last few years the number has scarcely exceeded 150,000. This year it is unlikely to reach half that level, and little of it will be social housing. Increased house-building programmes would both stop the development of credit bubbles based on artificially inflated house values and would have a ‘public works’ effect as an expansionary mechanism should the economy go into serious recession. The housing market obviously has to be restored – some want to sell and others want to buy – but not on the pattern of the last thiry years.

Governments must also reduce the demand for private credit. Since it is unlikely that people will lower their lifestyle expectations very much, and since falling house prices diminish their value as security, the only way demand for credit can be reduced is by increasing the income of those who want it. That is something any British government would hate to do because it involves redistribution, which in turn involves the taxation of high incomes. But if there isn’t to be some form of income redistribution, we will be back on the same old treadmill.

British governments, of whatever party, should also think carefully about our relationship with the United States. It is largely one-sided, has been very damaging and has left the political class in a world of illusions, a world where above-weight-punching is thought indispensable. Gordon Brown has been careful to emphasise that the banking crisis had its origins in the US. In one sense that is self-evident: almost any crisis in American banking is going to be a crisis in Europe. But it is an error to assume that the lending and borrowing practices of the demutualised societies in Britain, or Brown’s role in encouraging those practices, were immaterial. The run on Northern Rock was, after all, the first and so far the only serious run on any bank anywhere. Equally immaterial, Brown would like us to think, is his own profound admiration for the economic and financial system of the United States. Although our own bankers hardly needed it as a model, it has been New Labour’s model, whether Brown admits it or not, as it has been the Conservatives’. If the crisis induces the government to increase its distance from the United States and display greater scepticism as to its financial and economic virtues, that is only to the good. But it will be difficult for New Labour, since the ideological superiority of the US over ‘Europe’ has been central to its formation. And it will be even more difficult for the Conservatives. If anything, their illusions are stronger, heightened by the party’s infantile and dangerous Europhobia. It has been under Cameron (who must surely know better) that the Conservatives have threatened to withdraw from the Christian Democratic grouping in the European Parliament and join the ratbags of the extreme right. Cameron might still be the favourite to win the next election, but the last few weeks, to the extent that they have forced disagreeable choices and unpalatable facts on him, have tested him more than anyone else.

9 October 2008

Ross McKibbin is a fellow of St John’s College, Oxford, and the author of Classes and Cultures: England 1918-51 and The Evolution of the Labour Party: 1910-24.