Does the UK have a sensible strategy for recovery? Just recall: the last time it tried the credit-expansion route to growth, it ended up in a huge financial crisis. Why should it rationally expect a different outcome this time?
Indeed, it is astonishing how little this crisis has shaken conventional wisdom. On the contrary, it is widely believed that it is safer to rely on private borrowing than on public borrowing as a source of demand. An expansion of private borrowing to buy ever more expensive houses is deemed good, but an expansion of government borrowing, to build roads or railways, is not. Privately created credit-backed money is thought sound, while government-created money is not. None of this makes much sense.
The credit machine is indeed beginning to work, once again. As Mark Carney, governor of the Bank of England, remarked in presenting the new inflation report this week: “This has led households to save less and spend more, and has prompted a strengthening in the housing market.” But we have seen this play before. It ended as a tragedy.
The BoE’s forward guidance is intended to keep this party spirit going by convincing the revellers it will not remove the punch bowl too soon. As Mr Carney told us, its main aim was to help the nascent recovery by “reassuring households and business across the UK that the bank would not raise interest rates until jobs, income and spending were really growing”. This worked.
True, unemployment fell faster than the bank expected. That is an embarrassment, but an acceptable embarrassment. Now the BoE is indicating it does not need to raise interest rates soon and, when it does, it will do so gradually. Its predictions of its own actions might turn out to be wrong. That would make it look a bit silly. So what?
What is really important is whether the strategy can deliver a balanced and sustainable recovery. That, Mr Carney admitted, is not the case so far. Adair Turner, erstwhile chairman of the defunct Financial Services Authority, has laid out the question in a lecture just delivered in Frankfurt: over several decades before the crisis, private sector credit grew faster than gross domestic product in most high-income countries. The danger is that “we seem to need credit growth faster than GDP growth to achieve an optimally growing economy, but that leads inevitably to crisis and post-crisis recession”.
The pre-crisis leveraging of the UK and other economies did not generate classic signs of overheating, particularly inflation. Instead it generated a financial crisis, a deep recession and a weak recovery. Now, in the UK, people are celebrating the restarting of the very process that ended in this huge disaster. Indeed the inflation report explicitly notes the easing of credit conditions, shown in rising credit growth, as a reason for greater optimism. How far is the optimism justified in the long term?
One argument would be that the private sector has now deleveraged. The ratio of household debt to income has indeed fallen, from a peak of 163 per cent in the first quarter of 2008 to 137 per cent in the third quarter of last year. But this has brought it back only to 2004 levels: soon, household indebtedness could be where it was in 2008.
Another source of optimism would be that the financial sector is better capitalised and regulated this time. The inflation report notes, for example, that common equity in UK banks has risen by £140bn since the crisis. Moreover, the BoE’s Financial Policy Committee is a more alert regulator of systemic risk than what was in place before the crisis. Yet this raises two opposing possibilities: one is that credit would not expand enough to support the hoped-for growth in demand; the other is that a better-capitalised financial system might generate even higher leverage in the rest of the UK economy than before. This might more than offset increased financial sector stability.
A third source of optimism would be that the expansion in credit seen before the crisis is not needed to sustain the growth in demand. About 80 per cent of UK bank lending is for household mortgages or commercial property, if one nets out lending within the financial sector. In principle then, a far lower rate of credit growth might be consistent with fast investment growth. But this, too, is questionable. It is likely that a surge in credit for purchases of existing properties is a condition for sustained growth of consumption and construction of housing.
A worry, then, must be not that the BoE would fail to reignite the credit engine but that it would succeed. Moreover, the result would not be inflation but a bigger expansion in leverage than ever before. The results could be dire, not least because the government’s ability to act as spender of last resort is also now more limited.
Is there a way out? Export-led growth would be one, though that only shifts the credit growth abroad. A far more radical possibility is monetary financing of government deficits. That is unthinkable now. But who knows where the next crisis will bring us? For now, remember that credit addiction is dangerous.
Copyright The Financial Times Limited 2014