Gareth McKeever and Manish Singh: The financial system is stabilised, but the real economy is in danger of a serious recession
Gareth McKeever is the Prospective Parliamentary Candidate for Westmorland & Lonsdale. Gareth has spent the last ten years advising investment funds on Japanese equities, most recently at Morgan Stanley. Gareth is a trustee for Honeypot children's charity and is an advisor for the Alpha Course.
Manish Singh is a graduate of Indian Institute of Technology. He is an Investment Director at SG Hambros Bank and is Head of Structured Products, advising clients on investments and asset allocation. He is also the Head of the Conservative City Future Research Group.
The Real Economy is Still at Risk
Let us make no mistake, the banking system may be stabilised but banks are not going to start lending at anywhere near the pace of recent years.
Increasing levels of debt have helped fuel economic growth and, for the foreseeable future, banks are going to be 'repairing their balance sheets', a euphemism for dramatically cutting back on loans to businesses and consumers alike.
We have already seen what a fall in mortgage loan growth does to the housing market and we should be prepared for a similar hit to business, with a subsequent sharp rise in unemployment, unless the government takes action fast.
One of the conditions for government support of the banks is that they start lending to businesses and providing mortgages to the consumer. However, there is much uncertainty as to what this means in practice and whilst the spectrum of products available may increase they will likely be offered at a much higher price. Furthermore, the government has a chequered history of white elephant capital projects and lending by government diktat is in no-one’s interest.
The Funding Gap is at Extreme Levels
To understand why the banks remain unwilling to lend we need only look at the 'funding gap', defined as credit extended to the UK private sector and public sector (loans and securities) less deposits and money market instruments placed at UK banks by the UK private sector and public sector. This gap is funded by wholesale funding, including debt issuance and borrowing from overseas.
According to a recent Citi Economic Research note, In August this year the funding gap was up to £667bn (46% of GDP), having grown from £163bn (19% of GDP) in 1998. That extra funding gap has been funded by a sharp rise in debt issuance and in net borrowing from overseas by banks, especially overseas banks, leaving the UK banking system - and hence the economy - more vulnerable to a tightening in global credit availability
The size of the funding gap and deteriorating economic situation will continue to deter well-capitalised lenders from making new loans and, whilst it may be prudent for each individual bank, household and company to retrench, the collective effect of such retrenchment would be devastating for the UK economy.
A Strong Fiscal Response is Necessary
The government needs to start thinking about how it will stimulate flagging personal spending and how it can encourage ongoing business investment. There is a lag between tightening credit and increasing unemployment and thus there is a small amount of time in which to take action before businesses start to close and jobs start to disappear.
All fiscal stimuli must be Timely, Targeted and Temporary, and all measures should result in money being spent, rather than being used to pay down debt or saved.
With that in mind we should look at tax rebates for consumers and tax incentives for businesses.
If we want money to hit the economy directly we need to focus on tax rebates, as opposed to tax cuts. Targeted tax rebates can quickly put money into wallets and a large proportion of rebates goes to people who are likely to spend it. A % tax cut may benefit the high earner more than someone on a low income, with a much smaller proportion being spent.
Likewise, tax incentives that stimulate investment, for example, ‘investment tax credits’, are more helpful than a cut in corporation tax. Companies don’t spend money just because its there to spend. In order to justify investment companies must see a net positive return. Ordinarily a positive return is predicated on an expectation of strong growth in demand. In the absence of such an expectation, incentives to invest are crucial.
Financing a Fiscal Response
It is important to emphasise the temporary nature of any fiscal action. These must be one-off adrenalin injections, rather than on-going medication. Indeed, only by emphasising the temporary nature of such action can we go some way to justifying the rise in government debt necessary to pay for it.
It is at times like these that government finances should be in a healthy state. For that reason many countries around the world have run budget surpluses, putting something away when times are good for the proverbial rainy day. Not so the UK. Many have pointed out that our cupboard is bare. Sadly this is not the case: it is not only bare, it is already heavily mortgaged.
The only positive point to be made with regard to levels of government borrowing is that with risk aversion high and consequent yields on Gilts at extreme low levels, there has rarely been a better time for the Government to raise capital. The Government should take advantage of this positive pricing environment to raise money to finance a strong fiscal stimulus package.
A funding gap at extreme levels will continue to drive borrowing and lending lower. A sharp rise in unemployment will duly follow and without a strong fiscal response the recession will be long and deep. The Government has successfully stabilised the patient, now it must get the blood circulating to all parts of the body.