What next?

Osborne needs a change of direction, says top former Bank of England official
December 20, 2012

Man of Steel? The chancellor visits Port Talbot works

While serving on the Monetary Policy Committee, the committee at the Bank of England that sets interest rates, I avoided addressing directly the current government’s Plan A for economic recovery through austerity. I felt and feel that sitting central bankers should not publicly comment on fiscal policy beyond forecasting its short-term effects, or on structural matters. Silence, however, was not assent on my part. For two-and-a-half years, the coalition government’s economic policies have focused on the wrong narrow goal, been self-defeating in pursuit of that goal, and in so doing have eaten away at British economic capabilities and confidence. It is past time for me, and far more importantly for the chancellor, to say so. Unfortunately, his Autumn Statement reiterated the same misguided priorities of deficit reduction and the same failed approach, with only minor variations.

The coalition government has failed to address the shortfall in productive British investment. As many have pointed out, British capital investment, public and private, has been well below the level of that of its international competitors like Germany, France, Japan, and the US. Addressing the shortfall requires structural, supply side measures, as well as a demand or stimulus agenda that fits with those measures, and is by definition business supporting. It requires confronting the real deficiencies of the British financial system with the same reformist zeal with which governments took on labour market liberalisation in the 1980s and 1990s. For at least 100 years, the City has far better served global finance than British domestic business, and that means the UK government needs to develop alternatives to the City for internal investment.

First, fiscal stimulus—or at least significant slowing of fiscal consolidation—should be adopted in the form of aggressive investment tax credits to non-financial business. Investment tax credits channel investment to directly where the shortfall lies, raising productive capacity and thus tax revenue over the longer term—certainly far more than consumption tax cuts. The UK government should go further, changing corporate governance rules to make it less attractive for businesses to sit on cash, e.g., by making large cash corporate holdings that are neither invested nor returned to shareholders as dividends over a two-year period automatically subject to a vote at the Annual General Meeting. It is understandable in the aftermath of the crisis that businesses want cash buffers and are risk averse. What is incomprehensible is the government playing with a long list of proposed tax adjustments from the Pasty Tax on up over the last two years, and never proposing a serious investment credit.

Second, the UK needs to create a credit market that lends to projects in the small and medium business sector that can’t get credit. Right now, the British economy is lacking the diversity of lending sources that the US and Germany have, with no small or community banks, a very high minimum company size required to float corporate bonds, and tiny corporate paper and venture capital markets. Countries around the world are passing laws, issuing charters to specialised financial institutions, making markets to allow companies to borrow from the market by issuing bonds (in conjunction with the central bank), and encouraging new entrants to create just such infrastructures in their own economies. Both Latin American and South East Asian emerging markets have made huge strides in domestic credit and capital creation in recent years through such policy efforts. It is time the government learned from these initiatives, and benefitted from the handbooks that the IMF and World Bank have written for how to do so.

Third, the government needs to create more competition in domestic banking, as the Vickers Commission has bluntly and rightly advocated. The current British banking oligopoly creates distortions—for the world’s eighth largest economy to have essentially only five domestic lenders (plus one very large mutual doing mortgage loans) is extraordinary and, as liberal economics would tell you, distortionary and inefficient. The government should sell off parts of the banks currently under its (meaning public) ownership control, just as it would break up any instance of excessive market concentration. As importantly, it should change the rules governing the entry of new banks into the system, and encourage the expansion of the banks tied to supermarkets and the like. Regulators should make banks more transparent, fees and application forms for loans should be standardised, and services should be mandated to assist microbusinesses and small or new firms with such applications.

Fourth, to further promote both domestic financial development and bank competition, the government should create a sizable specially chartered public bank for lending to small businesses, and accompany it with creation of a Fannie Mae-like company to bundle, securitise, and sell those British enterprise loans. Since I first advocated this approach in September 2011, many British officials and business leaders have taken up the call, including the British Chambers of Commerce, the Labour party leadership, and the current business secretary Vince Cable. The chancellor’s autumn statement, however, omitted any commitment to creating such an institution, and it is clear that any efforts the current Treasury would make in this useful direction would be insufficiently ambitious. Again, most of the UK’s major competitors, including Germany, France, and the US, have such banks—so state aid rules are not a real barrier—and provide better funding for small and medium-sized business. Concerns about reducing the franchise re-sale value of the semi-nationalised banks in UK government hands is about as classically penny-wise and pound-foolish, from a growth and investment perspective, as one can get. It is also moot, given that no one is going to be reselling those banks at a profit for years to come (another argument for selling off parts, as argued above).

Finally, the government should restore public investment levels, with an emphasis on large infrastructure projects. As Gavyn Davies, former chief economist at Goldman Sachs, has pointed out, British public investment has fallen by a quarter since 2010. That is a huge reduction, and is self-defeating in terms of short-run revenues and long-run growth. Besides, some humility about criticising wasteful investment is called for after the throwing away of private investment funds in the bubbles and frauds of the 2000s. Figures as politically different as Gordon Brown and Michael Heseltine have pointed out that the UK can get ahead in public-private partnerships and even sell stakes in large infrastructure projects abroad.

The MPC and Bank of England can and should support this pro-investment agenda, once it is pursued by a government, as I have been arguing for some time, right up through my last two speeches as a member of the MPC last summer. The Bank of England can purchase assets other than UK government bonds, particularly loans and bonds for public-private investment funds, and loans from the newly created banking entities, thereby simultaneously providing more effective monetary stimulus and giving British businesses access to more credit. In its new financial supervisory role, the Bank of England can enable new entrants to increase competition, and increase transparency of fees and counter other oligopolistic behaviors in the current British banking system. And the MPC and its members should stop talking about the need for reductions in spending when forecasting British economic growth and inflation—as argued above, the economic argument goes against such scaremongering. Furthermore, statements to this end from the MPC officially feed the policy defeatism and austerity cycle that is currently doing so much harm to British economic policy and the British economy.

It is not enough for Messrs Cameron and Osborne to claim that they have done what they promised to do. Their policies have left the British economy malnourished, and indeed made parts of it quite ill. There are alternatives available, and the British government should switch to these now.