Howard Flight: The Conservative response to the banking crisis and its implications

Howard Flight is a former Shadow Chief Secretary to the Treasury and recently set up Flight and Partners Recovery Fund. He is author of the Centre for Policy Studies pamphlet, From Boom to Bust: A Plain Guide to the Causes and Implications of the Banking Crisis.

While I believe people know that it was Gordon Brown who caused the borrowing and lending binge which has now imploded, it is important for the Conservatives to both understand and explain his underlying mistakes in monetary and economic policy and the regulatory failure.

Banks lend incautiously when the money supply grows too fast.  The underlying cause of the latter was Brown’s 2.5% consumer inflation target for the Bank of England.  While in a relatively closed economy such as prevailed until the 1980’s, excess monetary growth and demand feed through to retail price inflation; in an open global economy they cause asset price inflation and rising imports.  It was apparent five or six years ago that consumer credit card debt, mortgage borrowing and house prices were already rising too fast.

More widely, it is now clear that Brown’s “economic miracle” of ending boom and bust was a mirage.  Since 2001 reported economic growth reflected consumption growth financed by unsustainable levels of borrowing and the massive and unproductive increase in public sector spending and employment. This pushed the public finances into deficit at a time in the cycle when they should have been in surplus.

The main regulatory failure was to have removed responsibility for banking regulation from the Bank of England and set up the tripartite collectivity of the Financial Services Authority, Treasury and Bank of England, which - as I warned when it was introduced - failed to act effectively in a crisis.  The lack of clarity as to the Bank of England, Lender of Last Resort doctrine was also unhelpful and neither the Bank of England nor the FSA recognised the growing risks to the banking system of commercial banks engaging in investment banking activities and derivative instruments.  This rendered the banking system vulnerable to potential defaults across a wide range of financial derivatives.

A deep and potentially long recession has now started, as the banking crisis has led to a massive destruction of asset values, damaging the ability and willingness of the banking system to lend and reducing the money supply.  The debate now is about what measures the Government can or should take to support the economy when the public sector deficit is likely to rise to £100bn as the result of lost tax revenues. 

Planning and consultation constraints mean that it would be impossible to activate public sector infrastructure projects in sufficient time. Government should look at how it could help accelerate private sector infrastructure investment in the transportation, energy and water industries.  The Governor of the Bank of England has also succeeded in stimulating what has become a near 25% depreciation of Sterling against the Dollar which should be helpful to the UK economy (analogous to coming off the Gold Standard in 1930) although there is a risk of Sterling depreciation getting out of control.  Last week's substantial interest rate cut was welcome, but further cuts may prove necessary.  With falling consumption and massive asset price deflation, in the near term, the risks are of deflation rather than of inflation.

The SME sector needs all the support it can get.  It employs 14 million people and is particularly vulnerable to banks, both cutting facilities and upping their charges.  The Government might look at beefing up the existing Small Companies Loan Scheme and making it more accessible.  At a local level, Westminster Council has introduced a 17 point action plan covering a range of helpful initiatives including settling small company invoices within 7 days; the provision of professional advice to small companies on survival and to individuals on becoming self employed; the provision of professional advice to citizens with debt and mortgage problems; a Council sponsored youth apprenticeship scheme and a modest programme of additional capital spending.  If the recession turns out to be as severe as I anticipate, personal and company tax cuts should be considered, but only if they can be sustained – otherwise, as has been the US experience, they will only prolong the agony.

In terms of party politics, a failing Labour Government and Prime Minister have suddenly regained some credibility.  It is always difficult for an Opposition when the Government of the day grabs the headlines in a crisis.  It was correct for the Conservatives to have supported the crisis measures to underpin the banking system.  I believe we should also support whatever measures look practical and sensible to sustain the economy from slipping into depression.  While the scope is limited because the public finances are already in such a mess, in the short term there is a case for any worthwhile “Keynesian” infrastructure investment which could be implemented promptly, to keep up aggregate demand.

Looking forward to the next election, the key point is that only a Conservative Government would have the right instincts and commitments to change tack once the economy is recovering, and get back to the vitally needed long term measures of downsizing the State, sorting out the public sector and releasing the resources for the private sector to restore economic growth.