Central banks colluded in an endless cycle of credit expansion

It is time they set a lead.

My daughter, who knows a thing or two about the human body, keeps on telling me “Breakfast doesn’t count”, as we sit opposite each other of a morning eating our opposing meals – macerated fruit (me) versus two chocolate croissants (her). The point – her point – is that early on in the day you could chug down a cup of duck fat without consequence because you are going to burn it off anyway as you go about your day. It’s what you eat the rest of the time that makes the difference.

If you were setting up a bank from scratch today (for convenience let’s call it Stewart Cowley Unlimited Mortgage Bank – SCUM Bank for short) you would think pretty much the same way – you could eat as much risk as you wanted at the beginning because within not very long you would burn it off – all you need is rising property values as you go about your day. For instance, if house prices were going up at 5 per cent a year for five years then the loan you made would be only 78 per cent of the value of the house. As a banker your only thought would be – "If the borrower stops paying I could sell the house and get my money back even after all the other fees – happy days. Is that a bonus I see before me?"

Do the same calculation for 7 per cent house appreciation and the value of the loan is now only 70 per cent of the house value. And don’t forget this is with a 100 per cent mortgage; make the borrower put down 20 per cent up front and, after five years, these loan-to-value ratios drop to 62 per cent and 56 per cent respectively. In other words the cushion you have as a banker from making a loss is simply enormous. You understand why it is in just about everybody’s interests, in a functioning capitalist economy, that house prices keep on rising at a more or less steady pace; banks win, homeowners win, regulators win, politicians win.

More to the point, should things go wrong for some borrowers the chances of losing the money of the people you borrowed off in the first place (depositors) is minimal and what’s more, as a bank, you don’t have to put too much money aside for a rainy day to cover any losses that may arise from bad loans.

And so the system gets bigger and bigger – depositors are blissfully unaware of the risks being piled up and banks begin to function on wafer-thin reserves of money. And why shouldn’t they? In the US on rolling five year periods house prices rose by about 5 per cent for 30 years. Here in the UK it was just under 9 per cent with barely a pause for breath. It is a situation with some risks, many virtues and even more vested interests all aligned to keep it going.

You also understand why banks and bankers don’t self-limit; experience tells them that it isn’t necessary. Setting legislation that increases the amount of money bankers put aside for a rainy day, like those being introduced by the US and under the Basel III criteria, is against their instincts and experience. It has even led JP Morgan CEO Jamie Dimon to declare them “Un-American” because the idea of control is anathema to them.

So if you really want to control bankers you have to control the borrowers. Increasing interest rates to penal levels will stop the mathematics working. But we have had a generation of central bankers that colluded with the system and invented excuses not to rail in the excesses of either the lenders or the borrowers; interest rates were kept in single digits whilst house prices were rising by double digits in the run up to the peak in 2007, bolstered by the convenient theory that risks were being smeared around the system so thinly that no one would get hurt.

In fact risk was being concentrated in the hands of a few with disastrous consequences. Alan Greenspan, the Federal Open Market Committee and Sir Mervyn King and the Monetary Policy Committee of the Bank of England are all culpable in that sense of being unwilling to dish out the harsh medicine when it was needed. It’s something that shouldn’t be forgotten as we reignite the credit cycle, especially in the US, and watch as house prices rise, once again, far above the cost of borrowing. We need a new generation of central bankers prepared to lead, not follow.

Source: Bloomberg



Photograph: Getty Images

Head of Fixed Income and Macro, Old Mutual Global Investors

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Why relations between Theresa May and Philip Hammond became tense so quickly

The political imperative of controlling immigration is clashing with the economic imperative of maintaining growth. 

There is no relationship in government more important than that between the prime minister and the chancellor. When Theresa May entered No.10, she chose Philip Hammond, a dependable technocrat and long-standing ally who she had known since Oxford University. 

But relations between the pair have proved far tenser than anticipated. On Wednesday, Hammond suggested that students could be excluded from the net migration target. "We are having conversations within government about the most appropriate way to record and address net migration," he told the Treasury select committee. The Chancellor, in common with many others, has long regarded the inclusion of students as an obstacle to growth. 

The following day Hammond was publicly rebuked by No.10. "Our position on who is included in the figures has not changed, and we are categorically not reviewing whether or not students are included," a spokesman said (as I reported in advance, May believes that the public would see this move as "a fix"). 

This is not the only clash in May's first 100 days. Hammond was aggrieved by the Prime Minister's criticisms of loose monetary policy (which forced No.10 to state that it "respects the independence of the Bank of England") and is resisting tougher controls on foreign takeovers. The Chancellor has also struck a more sceptical tone on the UK's economic prospects. "It is clear to me that the British people did not vote on June 23 to become poorer," he declared in his conference speech, a signal that national prosperity must come before control of immigration. 

May and Hammond's relationship was never going to match the remarkable bond between David Cameron and George Osborne. But should relations worsen it risks becoming closer to that beween Gordon Brown and Alistair Darling. Like Hammond, Darling entered the Treasury as a calm technocrat and an ally of the PM. But the extraordinary circumstances of the financial crisis transformed him into a far more assertive figure.

In times of turmoil, there is an inevitable clash between political and economic priorities. As prime minister, Brown resisted talk of cuts for fear of the electoral consequences. But as chancellor, Darling was more concerned with the bottom line (backing a rise in VAT). By analogy, May is focused on the political imperative of controlling immigration, while Hammond is focused on the economic imperative of maintaining growth. If their relationship is to endure far tougher times they will soon need to find a middle way. 

George Eaton is political editor of the New Statesman.