Clarifying Deleveraging, or, Saving the Economy

Earlier today I wrote, a little sloppily, that:

“…the only way to arrest the deleveraging process is to increase the capital able to support lending.”

“Deleveraging” should be defined as a reduction in gearing, i.e. a reduction in the ratio of borrowing to risk capital.  This could be achieved by reducing borrowing or increasing risk capital, or a combination of the two.

What I really meant to say, then, was that the only ways to maintain lending levels are to:

• increase the risk capital employed; or
• reduce the riskiness of lending.

The problem we face is that capital is fleeing to safety – yields on Treasuries are breaking records – and lending is perceived to be riskier than before, not less risky.  Only a few contrarian investors are putting their toes into the water and, in the case of Northern Rock, for example, rather than support them, the UK government has seen fit to expropriate their investments.  Not a lot was done to see Woolworth’s through the shock of denial of trade credit insurance, which appears to have demanded so much working capital Woolies didn’t have to have pushed it from turnaround possibility to insolvent virtually overnight.  Government concern seems to be limited to protecting jobs until the New Year by some kind of behind the scenes deal, even though the administrators would have needed to keep the stores open anyway to conduct fire-sales of stock (destroying more capital in the process).  In the absence of new risk capital, preserving the 30,000 Woolies jobs in the longer term will likely prove impossible.

Despite the recapitalisation of the banks, it’s difficult to see how overall lending levels can be maintained until a floor is put under the destruction of risk capital (Sir James Crosby agrees – see below for more discussion of his report).  If the government takes on too much debt [or risk – and note that fully nationalising the major banks, as the loonies are talking about, would be to take on the risk of entire multi £100 billions balance-sheets], Brown will likely become the next Callaghan, cap-in-hand to the IMF. We can’t simply spend our way directly out of trouble. The focus should be on investment, not VAT reductions.

We’re therefore going to have to make some choices on lending.  Broadly, if we have any brain-cells, we will realise that we have to reduce mortgage and consumer lending, and, if possible, increase lending to business.  It seems to me we should simply let the banks do this.  Allowing them to increase real interest rates to consumers (but likely still reduce nominal interest rates) would help rebuild their balance-sheets.  Interference may well be counter-productive, since the government has the ulterior motive of needing to keep the voters happy in the short-term.

Here are three scary indicators (apart from the VAT reduction) that the UK’s establishment is in headless-chicken mode.  In the words of everyone’s favourite football chant, Darling, “you don’t know what you’re doing”:

(1) Having slept on it and having printed off the Introduction (actually a Summary) to his report, I am even more astonished than before that Sir James Crosby (a mortgage-banker, of course!) thinks we can or should actually increase net mortgage lending over the next couple of years.  If we do this, the result, sure as eggs, will be to reduce other forms of lending, i.e. to corporates.  This will lead to more redundancies and defaults on mortgages…  Crosby, bizarrely, seems to consider the mortgage market in isolation to the rest of the economy.  I repeat, house-price falls per se will not lead to defaults in the UK (because we don’t have no recourse loans).  As long as interest rates don’t spiral up, unemployment will be the main cause of defaults.  We therefore need to keep people in work, by preventing unnecessary corporate bankruptcies.  Like Woolies.  Good start, guys.

(2) Today’s Grauniad included a graphic (not included in the online version of the article) showing what countries were spending money on to try to boost their economies.  The UK blob starts with “tax cuts”.  Germany?  “Infrastructure, green technology and tax breaks on new cars” (not sure about the cars!).  France?  “Help for industry”.  Spain?  “Extra spending on roads, transport and tax relief over 2 years”.  Only the UK, it seems, is borrowing for consumer spending on imports.

(3) Then there’s Mervyn King’s confused remarks to an MPs’ Committee.  Nils Pratley, among others, expresses his puzzlement.  He runs some numbers and reaches the conclusion that: “There is a funding drought.”  I say again, do we want to sacrifice good firms to try to maintain what looks more and more to have been a house price bubble?

Interest rates are likely to be decreased even further next week.  And again, the banks’ arms will be twisted to reduce their SVRs, preventing them from rebuilding their capital.  And preventing them from supporting businesses (the failures of which will blow more holes in bank balance-sheets) and reviving the economy, leading, in the longer-term, to less new mortgage lending, more defaults due to unemployment and an even greater drop in house prices than would otherwise be the case.