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Osborne and the next crunch

• Robert Peston
• 8 Apr 08, 09:33 AM

We may not yet be free of the ill effects of the credit crunch, but how do we prevent it happening again? Well George Osborne has a plan 鈥� though it鈥檚 still in the work-in-progress file, which is presumably why it was unveiled many miles from home in a speech he gave last night at Harvard.

This speech may, however, turn out to be Osborne鈥檚 most significant policy speech as shadow chancellor. In it he signalled a willingness to consider radical reform of monetary policy with far-reaching consequences for the .

He said 鈥淭he credit cycle demonstrates starkly that controlling retail inflation is not enough. Recent threats to stability have come not just from the demand cycle but from the credit cycle.鈥�

What he means is that governments and regulators across the world 鈥� but especially in the UK and the US 鈥� were wrong to regard the sharp increase in borrowing by households, companies and financial institutions as a benign phenomenon.

We were gulled into thinking our economies were stronger than they really were, he argued, by all those years of steady growth and low inflation. And because of the massively deflationary impact of the transformation of China and much of Asia into great exporting machines, central banks set interest rates at levels that sparked a great boom in borrowing.

鈥淲e are now all discovering that the extra liquidity has flowed not into retail prices, but into asset prices and unsustainable increases in household balance sheets,鈥� Osborne said. 鈥淔or a long time this has been good news for home-owners and investors, but it is at the core of the problems we now face.鈥�

Or to put it another way, our economies are caught in a vicious spiral of banks realising they have lent too much to those who could never afford to repay, which is prompting those banks to rein in the credit they are providing, which is in turn precipitating a fall in the price of houses and other assets, whose poisonous effect is to turn the banks鈥� fears about rising losses on loans into painful reality.

So what鈥檚 to be done? Well, Osborne believes that the monetary authorities 鈥� in our case the Bank of England 鈥� need to take greater account of inflation in the price of houses and other assets when endeavouring to promote economic stability.

But he concurs with the chairman of the , , that economic instability might actually be exacerbated if central banks were to use only interest rates to control both asset prices and consumer price inflation as conventionally measured.

Thus there may have been times in the past few years when a sharp rise in interest rates to restrict the growth of credit might have had a dangerously deflationary effect on the wider economy.

Osborne is therefore attracted to a proposal put forward last year by a former member of the Bank of England鈥檚 monetary policy committee, , whose effect would be to impose restrictions on how much banks can lend during years of strong economic growth and would ease those restrictions when the economic cycle turns down.

As a theory it is attractive (and, by the way, should perhaps also be adopted by the government in its management of the public finances). It would work by giving monetary authorities, such as the Bank of England, the power to oblige banks to hold more capital in their balance sheets relative to their loans or assets when the economy is growing strongly and less capital when 鈥� like now 鈥� it would help if the banks could be encouraged to lend a bit more.

So, for example, in the good years the banks could perhaps lend 拢13 for every 拢1 of capital they hold 鈥� and that could rise to 拢17 in less benign times.

Turning this banking theory into practice would not be easy, however. Determining the appropriate level for capital ratios at any particular point in the economic cycle would probably turn out to be more art than science.

And, arguably, it would be unfair, in a global market for banking, for the UK to unilaterally impose higher capital ratios on British based banks 鈥� though securing worldwide agreement on a new system of adjustable of adjustable ratios could take years.

Also, what about the shadow banking system, which over the past few years has been as big and important as the official banking system? Securitisation may be dead right now, but it will reawaken one of these days. And it鈥檚 very difficult to see how the imposition of capital constraints on regulated banks would have any impact on the provision of credit by the holders of giant pools of liquidity all over the world via their purchase of asset-backed securities.

What got us into the mess we鈥檙e in wasn鈥檛 direct lending by our banks: it was the way they packaged up loans to homeowners and highly leveraged businesses into securities for sale to investors. So unless the largely unregulated providers of credit are somehow brought into the regulatory net, it鈥檚 not clear that imposing new capital constraints on banks will have much of an impact.

PS. Traumatised by the snows of spring, this column will go into sleep mode for a few days. Here鈥檚 hoping for warmer winds and green shoots on my return.

PPS. From 1800 on 16 April (UK time), we'll be doing some essential maintenance to all of the 主播大秀's blogs. As a result of this, you won't be able to leave any comments on our blog posts from that time until early morning on 17 April. More about this on the Editors' blog.

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