The decision of the British government to rescue Northern Rock, the mortgage lender, with billions of pounds of taxpayer’s money, represents a terrible long-term blunder, in my view. It may also put the UK afoul of EU law, for those that care about such matters. Of course one feels very sorry for the people who have savings with NR and I suppose many of them are mightily relieved at the turn of events. I am sure I would be relieved if I were in their position.
But hard cases make bad law, and bad policy. Consider what has happened: a company gets itself into a pickle because its funding policies are up-ended by a sudden rise in short-term interbank borrowing costs; fears grow that the firm cannot make good all its commitments and a bank run occurs. Before the days when financial institutions of a certain size were considered too large to be allowed to fail, the collapse, however tragic, of Northern Rock would have been seen as a necessary if very nasty reminder that capitalism has its risks.
Banks and other institutions that lend money must not lend to people without being sure of the latter’s credit worthiness. But that caution has been thrown to the winds in recent years: in the US and Britain, for example, borrowing covenants have been relaxed, and pretty much any sentient lifeform has been able to get a mortgage. Some financial institutions are to blame for their plight although in mitigation, the price signals that are the essential feature of markets have been distorted by a long stretch of cheap money. The ultimate culprits, as I said the other day, are the central banks and their historically low interest rates. With so much cheap liquidity, the sort of returns investors made on safe investments were peanuts and so they took greater risks for often only a slightly higher reward. We are now moving to a position where risk is more realistically priced. The Northern Rock bailout undermines that move.
The rescue of Northern Rock also shows that the supposed success by Margaret Thatcher and even John Major in rolling back socialism is itself an exaggeration. It proves that if a company is big enough, it can call on the public purse. Northern Rock, based in Labour Party heartland of the north-east, has been effectively nationalised by the government, and inevitably, the clamour will grow for more and arguably more deserving groups of people to be bailed out. I can think, for example, of the hundreds of thousands of people who face retirement without a decent pension because Gordon Brown, when he was Chancellor, helped to shaft private sector pensions by changes to how equity dividends are taxed. They are arguably far more deserving of some form of recompense.
Of course, if the Tories had any moral or political backbone – and they most certainly do not – they would have denounced this state of affairs, rather than take the easy way out of playing to the gallery by supporting the tax-funded bailout of Northern Rock. Back in the mid-1990s, when Barings went down due to dodgy trades in the derivatives market, the collapse was seen as a harsh but necessary lesson about the realities of risk. For a while, Barings served as a useful warning, far more useful than any group of regulations. With the rescue of Northern Rock, careless financiers will now regard the state as an easy touch.
The Daily Mash gets it spot on.
Hopefully, the American government doesn’t bail out the subprime lenders that caused problems in the U.S. housing market. So far, they’ve let non-bank lenders go bankrupt, but there could be bailouts down the road.
Jonathan,
Wait till you see what’s coming next!
Northern Rock was up ended because banks were unwilling to lend at any price (probably because they wanted to hang onto funds for fear they would find themselves where NR is now). It may be seen as legitimate for the bank of Engliand to have loaned funds to NR in such circumstances at a high (penal even) rate of interest. NR’s mortgage book should be considered as adequate collateral for such a loan because, contrary to some comments, NR’s problems arose from their ill advised borrowing, not poor lending.
The unconditional guarantee given by the Bank however is another matter entirely. Now the precendent has been set how can they refuse to do exactly the same if the circumstances are repeated? What if the bank in trouble is the Mickey Mouse Bank of dodgy lending? It could be no more than a perfect example of moral hazard.
I have long thought this was overstated; Thatcher’s success was to stop the advance of the state for a few years but she never managed to reverse it. That may be seen as indicative of the scale of the problem!
Johnathan
The banking system, as you well know, is entirely dependent on confidence. A genuine run on bank deposits would be catastrophic. Hence i can understand why the govt have bailed out NR’s senior lenders.
It is worth noting that throughout the five years of the Asian crisis, in which 80% of the regions banks went bust, there was not a single case whereby senior lenders lost money. Subordinated debt holders took substantial hits in certain cases and and equity holders were largely wiped out, but not senior ranked deposits.
It is reassuring to see the 80% loss accruing to equity holders of NR. That will go some way to preventing moral hazard next time.
Anyway, NR is a moral hazard sideshow compared to Bernanke’s unbelievable rate move last night.
The Prime Minister’s reputation for sound stewardship of the economy when he was Chancellor of the Exchequer was to a large extent based on his early decision to grant independence to the Bank of England. Whilst I have never shared the generally accepted opinion of Mr Brown as being a competent finance minister, I was, nevertheless, pleased that he made that decision as I am of the view that the less politicians have to do with managing the economy, the better.
It’s quite clear now that the BoE is not independent in any real sense of the word. What puzzles me is that Mr Brown’s reputation, which should now be in tatters, has, if recent opinion polls are to be believed, improved. What does this say about the British public or, perhaps more relevantly, the Conservative opposition?
I also wonder how many of these huge deposits are windfalls from people who stiffed their banks claiming to have been “mis-sold” endowment mortgages in the early 90s.
It’s feeble.
Manual II – one of the good things about your Byzantine Empire (I have to say that there were many bad things – for example the endless rules and regulations from which we have developed the saying “Byzantine bureaucracy”) was that at least the money was sound (most of the time) – which is one reason the Empire lasted (against all the odds) for centuries.
Our money is wildly unsound.
As is our banking system – as pommygranate correctly points out it a shell game (where there is far more lending than REAL savings – when all borrowing should be from real savings, not book keeping tricks) dependent on the “confidence” the confidence tricksters try and maintain. And dependent, when this fails (as, in the end, it always does) on endless bail outs from the government.
As for Northern Rock:
First the Bank of England vastly increases the money supply for years (the stats are there if one searches for them hard enough) and then when bubbles emerge (which they MUST somewhere) it bails the system out.
It was, of course, not just Northern Rock. The government has said it will back EVERY deposit (no matter how large) in EVERY bank (off the chart moral hazard).
And the “independent Bank of England” has been splashing billions of moral hazard, corporate welfare money around the financial system over the last few days (with no excuse of war or terrorism or other such).
The next time anyone in the financial industy snears at welfare people, the poor can fling the recent events back in their faces – this is perhaps why the Economist and (especially) the Financial Times tend to the left. It is not consistent for rich people to collect subsidies (sweet heart loans and other such) and to oppose such welfare going to the poor – the French economist and legal thinker Bastiat (who opposed government aid for either) pointed this out more than one and half centuries ago.
In the United States:
Yes the people who lent out money on the subprime market were unwise (as were the people who borrowed the money to buy houses).
However, the funny money the Federal Reserve was pumping out over the last few years had to come out somewhere – if it had not caused a bubble in the sub prime area it would have just caused more bubbles in other places.
It is the Fed that is the base of the problem in the United States.
Both Alan bail-out Greenspan and the present Chairman.
Most people seem to learn nothing. Each time a bubble (created by the Fed) looks like it is going to burst the Fed is called upon to “save the economy” by pumping yet more funny money.
It often does just that – ignoring the fact that this just pumps up bubbles even more (i.e. it may put off recession – but it also makes recession, when it does eventually come, worse than it would have been).
The bail-out was probably the right thing to do.
The real problem is that the the whole system is crooked. In the UK all banks are subsidised in some shape or form by the Bank of England (aka the taxpayer). Hence they can lend more than would otherwise be the case.
The solution is to scrap all subsidy and regulation for banks and move to a true free banking system, rather than the semi-nationalised system we have now.
I do not agree with the first line of your comment Mr Blumfeld (past subsidies do not justify yet more subsidies).
But the latter two paragraphs make a lot of good points.
However, what do we mean by “free banking”.
Do we mean fractional reserve shell games (where some borrowing is not financed by REAL savings – but by book keeping tricks instead)?
If so, what happens when such enterprises collapse?
Does the law allow “suspension of payments” and does the govenment come in (via all sorts of ways) to bail them out?
Only if the fractional reserve banks are allowed to collapse (and their customers starve in the streets – as far as government is concerned), is this “free banking” anything to do with free market.
“But if banks and other financial institutions were not allowed to violate their contracts in various ways, and government never helped them at all, then the fractional reserve system would not work”.
Yes – exactly.
All the famous examples of “free banking” tend to fall apart when one looks at them closely.
Even the Scottish example in the 18th century was a fraud – as people who asked for their gold at a Scottish bank, when it did not feel like paying out, discovered (and corrupt courts sometimes ruled in favour of the banks).
There is a French saying “free trade in banking is free trade in swindling” and it is correct – IF “free banking” means taking financial institutions out of the law of contract.
There is nothing wrong with being a money lender – as long as you are really lending out money.
Your own savings or the savings of other people – i.e. money you, or they, have chosen not to spend.
But if you come with clever schemes to increase lending beyond real savings – in order to have two or more people spend the same money on different things at the same time…..
Well then you are not a money lender – you are boom-bust man.
Busy playing a shell game.
“But Paul you have not been specific about Northern Rock – you have just produced general rants of the type you have been writing for decades”.
Very well.
Northern Rock borrowed money (from the money markets) and lent it out to mortgage custimers (it did other things to, but let us leave it there).
Borrow short and lend long.
I would not have thought of doing that. No wonder I would never be considered for one of the clever people jobs.
Back in the Reagan era, free-market conservatives were worried about the precedent set by the federal government’s bailout of Chrysler. However, Chrysler paid back its loan ahead of time, and similar bailouts did not follow, SFAIK. Will Northern Rock be required to pay back the UK taxpayers?
Warning: tinfoil hat time.
Effective politicians have to grab opportunities to advance their long-term agenda. Given the first bank run of the 21st Century and turmoil elsewhere in the international financial system, could this be a great opportunity for a europhilic politician to give the replacement of sterling by the euro a push?
A little more fiscal irresponsibility at home, a little more international concern about sterling, and a prime minister might very reluctantly allow himself to be forced to bid farewell to the Bank of England. After that, it would of course be folly not to sign up to the latest euro-treaty-that-is-not-a-constitution.
Just wondering!
Paul:
First the Bank of England vastly increases the money supply for years (the stats are there if one searches for them hard enough)
I’m slightly confused. Over the last 10 or so years we have had the money supply increasing by around 12% pa to 14% pa; economic growth at around 3% pa which I thought should leave price inflation at around 10% pa. It’s actually been around 3% pa or so.
So where has the extra money gone and is it possible for it to “hide” and then surprise us a few years later?
The headline “inflation” figures do not accurately measure inflation. They are biased towards items that tend to fall in price, e.g. computers, consumer goods, etc, and excludes such things as house prices/mortgage costs.
We used to use the Retail Price Index, but Brown moved us on to the Consumer Price Index a few years ago, ostensibly to fall into line with other EU countries, but note that the CPI reports inflation figures often a full %age point lower than RPI. Both measures have the bias I outline above though. I don’t think this is an accident.
A vast rise in asset prices. Look at gold, commodities generally, oil, housing, commercial real estate, antiques, fine wine, classic cars, etc, etc.
Friedman’s monetarism may have its flaws, but its central thesis is correct: if you inflate the money supply, sooner or later the effects come out. One thing that has temporarily masked the inflationary impact of low interest rates has been the flood of cheap imports from China and the outsourcing trends of the last few years, which have capped wage increases. That impact, however, is a one-off; sooner or later, inflation will creep back into the system.
Quite so Johnathan (and Mr Hammerton) – even the C.P.I. does not really measure inflation (and the R.P.I. is a total fraud – worse than Mr Brown’s other frauds such as counting “tax credit” welfare payments as “negative taxation” – thus distorting the government spending and taxation stats at the same time).
Inflation is the money supply rise – even if “prices in the shops” do not rise at all.
For example, there was no great rise in the “price level” in the late 1920’s in the United States – but inflation was vast (straight into assets).
Of course, without increases in the money supply prices would tend to decline gradually over time (as better ways to produce goods and services were found).
This (as opposed to a sudden price drop caused by the bursting of credit-money bubble) would not be a problem.
What Jonathan said; but note most classes of assets have limited relevance in most people’s lives – real property prices, on the other hand are a huge factor, and their inflation gives rise to speculative markets such as packaged sub-prime mortgages… which is where we came in.
Thanks guys – very helpful and knitted together some of the other ideas/facts I had floating around in my head.
I’ve since been reading up on the Austrian School trade cycle theory – very interesting. Boils down to the credit expansion/contraction of the commercial banks (necessarily backed by the central banks) it seems. Maybe trade cycles are not inevitable after all!
Would any of you be able to recommend any particularly good books about money/trade cycle by the Austrians or others that would help my understanding?
Regards
I would like to Sam, but the Ludwig Von Mises Institute people would snear at me for being out of date (and they might be right).
I would advise going their website and going for something you like the look of.
On your basic point:
The boom-bust cycle is indeed not inevitable (although Mr Brown’s claims to have got rid of it are absurd). It is not a matter’s of Lord Keynes’ “animal spirits” it is a matter of more credit-money – the extra credit money has to come out somewhere.