Treasury Contents

Examination of Witnesses (Questions 20-39)


25 NOVEMBER 2008

  Q20  Mr Fallon: You think the path is credible. I want to be clear about that.

  Sir John Gieve: It is certainly achievable.

  Q21  Mr Fallon: Mr Bean, can you help us on the immediate effects? Is it not more likely, given the pressures on household finances at the moment and the reduction in credit that we have been discussing earlier, that people will simply save now, having been warned about tax increases to come, rather than spend, and pay off credit cards rather than use them?

  Mr Bean: There is always a worry with temporary tax changes that it may not lead to very much effect on spending. A temporary cut in Income Tax is likely to be saved, for instance. What you can argue, I think, is that a cut in Value Added Tax at least gives households an incentive to bring forward some spending from the future to the present—a sort of switching over time. In that sense, I personally think it is quite a sensible measure to go for in the current conjuncture, it is a measure that works because it is temporary.

  Q22  Mr Fallon: Dr Sentance, what was your view of yesterday's package?

  Dr Sentance: If you look at the borrowing numbers they are a product of two things: one is the stimulus that the Government provided through its cutting VAT and other measures but, also, the bulk of the increase in borrowing is a reflection of the deterioration in the outlook for the economy. When it comes to interest rate decisions looking forward, I think we will be making a judgment, on the stimulus from the fiscal package but, also, assessing the evidence that we have got from the progress of the real economy. The issue that we were just discussing, about how lower interest rates are feeding through into the rates actually paid by businesses and individuals, also has an important influence on the monetary stimulus that we are providing at the moment.

  Q23  Mr Brady: Governor, how long would you expect it to be before you can see whether the stimulus package is starting to have the kind of effect that was hoped for?

  Mr King: The "stimulus package" meaning yesterday or—

  Q24  Mr Brady: Yesterday in particular.

  Mr King: I think well into next year. As Charlie Bean said, obviously one of the likely impacts of the temporary reduction in VAT is that during the second half of next year there will be a lot of advertisements saying: "Buy now before VAT goes up in January 2010". So precisely when this expenditure-switching will occur is not entirely easy to judge. However, of course, the real problem is to know what the counterfactual is. It is very hard to judge the impact of any policy measure without knowing precisely what the counterfactual is—what would have happened had you not done it. That, simply, we do not know; we do not know how quickly spending would have tailed off, how orders would have declined. That is why in these circumstances almost any policy measure is really about trying to balance risks.

  Q25  Mr Brady: So it is not likely to have a direct effect on your decisions at your next meeting?

  Mr King: We will certainly look at our judgment of all the measures taken; we will go through the PBR very carefully and all the small print to see what other measures are in there in order to work out the overall impact and see what judgment we make about the time path of activity and output and, hence, the path of inflation. The big picture here, which we should not lose sight of, is that we are facing an extraordinary set of circumstances in which confidence in the banking system around the world has collapsed, thus making the finance of ordinary industry and purchase very difficult—not just expensive but very difficult. That is potentially very damaging indeed. Therefore, we do need to take measures to ensure that we solve that big problem. That is the big downside risk, and that is why I attach enormous weight to re-establishing the firm lending to the economy as opposed to marginal changes in the outlook for demand and activity which are the usual minutia that forecasters and policy makers focus on. This is really about a big downside risk.

  Q26  Mr Brady: Can I ask you and, perhaps, any of your colleagues to comment on the particular decision to reduce VAT on a temporary basis rather than some of the other things that might have been done? Does that impact more obviously on inflation in the medium term as opposed to demand, or is it principally a demand stimulus?

  Mr King: I think, as Professor Bean said, the idea behind it, at least in the textbooks, is that you can try to switch expenditure from one period to another. That has pluses in that you may be able to move expenditure to a period when otherwise you would expect demand to be rather weaker; it has minuses in that if you get the timing wrong and demand turns out to be weak just after you put the rate back up, then it may be switching expenditure at the wrong time. These are risks that need to be taken. There are enormous challenges for policy. Mr Fallon rightly pointed to the challenge posed by the overall scale of borrowing, and there is no doubt this is a major challenge, but we have to try and balance the risks. We are going to have a long, hard path back to fiscal sustainability because the debt has been increased not just by a downturn in the economy but, also, by the need to recapitalise the banks and provide so much lending to the banking system. This is a problem facing all Western governments—indeed, governments around the world.

  Q27  Mr Brady: Many people, after yesterday, are saying that a 2.5% cut in VAT is not going to make much difference; if you walk down the High Street you will see shops making cuts of 20%, 30% or more in prices. Would it not have been more effective, perhaps, to reduce National Insurance?

  Mr King: I do not think so. If you want to have the impact on expenditure switching, then actually doing it through VAT is probably more likely to be effective. We have seen in the past temporary incentives to capital spending have been used, like changing the rate of investment allowances. That is another measure that has been used in the past. People have focused on measures directly trying to switch the timing of expenditure.

  Q28  Mr Brady: So the effect comes towards the end of a temporary period, not towards the beginning?

  Mr King: It is more likely to but, of course, people who have been thinking of spending may decide that some point in the next year is a good time to spend, why not do it now rather than the second half of next year? Decisions will vary from one individual or household to another.

  Q29  Mr Brady: Finally, could I ask something completely different, to go back to your comments about the banking recapitalisation? One of the messages we were given fairly clearly in Japan was that one of the things that was crucial to them sorting out their problems was dealing with troubled assets. Is it not the case that one of the things we have failed to do so far in the UK is really get to grips with that problem of bad debts and troubled assets? Should some focus be turned to that rather than further recapitalisation?

  Mr King: That is very hard to judge, for two reasons: one is that I do not think it is obvious that we have, on the same scale of the United States, the same degree of bad assets—certainly originating in domestic lending. The second is that the United States found it very hard to work out a practical method for buying those assets without getting themselves in a position where they, on behalf of the taxpayer, were overpaying and getting the wrong assets offered to the government in an auction process. So from a process which began as a process designed to put in place auctions to buy toxic assets, in the end, they could not actually work out practical ways of doing it sufficiently quickly, and they switched the focus of their scheme more towards a recapitalisation of the banking system along the lines that the UK carried out. So I think there are good reasons for preferring the recapitalisation route, and if you go far enough with the recapitalisation then it should actually allow banks to absorb the losses that may occur on what bad assets they have down the road. The financing of those bad assets we have been able to provide help with through the special liquidity scheme. So we are the only central bank that has offered a scheme under which we are willing to lend for three years against assets held when the crisis hit in the second half of 2007. That enables the banks to finance those assets without transferring to the taxpayer the risk of loss on bad assets, because the banks may know which are the bad ones but we do not. Therefore, in any process of a sale the ones that you get offered in the auction are the ones you really do not want to buy.

  Q30  Nick Ainger: Governor, in response to earlier questions from the Chairman, you spoke about the availability of credit for the real economy. Obviously, the monetary stimulus comes through from the substantial cut in Bank Rate. How concerned are you that, in fact, that significant cut is not being passed on to the real economy whether it be for mortgage holders or small businesses?

  Mr King: I think we recognise that part of the process by which banks are recapitalising themselves is to increase the margin between the rate at which they borrow and lend. That margin reached unsustainably low levels in the first half of 2007—quite remarkably low levels. At times some of the lending that was being carried on was being carried on almost at a loss in the middle of 2007. So it was not surprising that from then on we have seen the wedge between the rate at which banks borrow and the rates at which they are willing to lend widen. We have seen, in the last couple of months, that the Libor rate has actually fallen by the full extent of our cut in Bank Rate. The spread has not fallen back, which we might have hoped, but the rate did fall back. It is clear that the rate on standard variable rate mortgages has fallen back by the full amount, but some of the banks that have tracker mortgages, following the cut of 150 basis points (1.5 percentage points) that we made earlier this month, withdrew some of the tracker products. They are now reintroducing them but at a higher rate, so that they have not fallen back by the full amount of the cut in Bank Rate. They have fallen back but not by the full amount. At one level I think the Committee understands that this means in such circumstances that we may need to cut Bank Rate by more than we would otherwise have done precisely to have the right impact on the rate that is being charged to final borrowers. We are conscious of that and that enters into our judgment about how we calibrate the required scale of the cut in Bank Rate. I think this is tied up with the issue of the willingness of banks to lend. My feeling is that the right strategy is to try and tackle head on this question of banks being willing to lend, and to cut the amount of Bank Rate that we think is necessary to ensure that after the margin has widened a bit then the appropriate cut is made in the rate charged to final borrowers. I think we should accept that part of the process of restoring the banking system to a more normal state is to allow that margin to widen. If we can solve the problem of the amount which banks are willing to lend then we will start to see the rates adjust in line with Bank Rate as they used to.

  Q31  Nick Ainger: How does that square with the statements that have been made by the Chancellor that he wants to see credit availability at the same levels as 2007 following, as you indicated earlier, the massive injection that has been made of taxpayers' money into the banking system?

  Mr King: I think that is a question you will have to put to him. We do not want to go back to the levels of the first half of 2007. I would not put it, myself, in terms of a particular number; I would like to feel that the banks would be in a position where they would be able to say to their branches and their managers: "Look, if you find profitable lending opportunities, lend". What is happening, at present, is that what the banks are saying to themselves is: "Even if we see some apparently profitable lending opportunities, we had better forgo them because we are under enormous pressure to reduce the scale of our leverage" (to use that awful word) "and we have to reduce the scale of our balance sheet." So they are giving up profitable lending opportunities in order to behave defensively and reduce the size of their balance sheet. Individually, it makes sense for a bank to behave in that way; collectively, it makes no sense at all, because if all the banks behave in that way not only will the economy go into a steep recession but the banks themselves will start to see even bigger losses on their pre-existing loans. So it is not collectively in their interests to behave in this way, and that is the challenge that we have to confront in dealing with the banks, which is to find a way in which their individual incentives do not lead to a collective outcome that is clearly adverse.

  Q32  Nick Ainger: Governor, on that point, what role will the new lending panel have? Will it be able to address those sorts of issues that the Bank is going to be represented on the lending panel? Is that a forum where these issues can actually be thrashed out? Thrashed out they must be because whatever the MPC does in terms of Bank Rate it is not having the effect that we would all like to see on the real economy.

  Mr King: I totally agree, and I think they have to be thrashed out. I think you will find that in a statement today there will be an announcement about widening the remit and the membership of that panel to make sure that it achieves exactly the conversation and discussion that you have just mentioned.

  Nick Ainger: Thank you.

  Q33  Chairman: Governor, on Nick's point about Libor, the Committee would like a note from you on Libor, because when the debate was taking place about the 1.5% cut being passed on, the banks, in discussion with me and others, said: "Wait a minute. This is getting too far. It's saying we are being forced to pass this 1.5% on; we've only charged people the Libor rate for mortgages." Amongst other things, Governor, it is a three-month rate. So if people are being charged that for their mortgages it would just produce chaos in the market. So we need to have a more fundamental understanding of Libor, and I was taken by Willem Buiter's blog when he said: "Libor is the rate at which banks don't lend to one another". There is a lot in here, and as a Committee we really want to explore this, so could you give us an initial answer on that and give us a comprehensive note?

  Mr King: You would like both an answer and a comprehensive note?[1]

  Q34  Chairman: Yes.

  Mr King: I can't better Willem Buiter's blog. It is in many ways the rate at which banks do not lend to each other, and it is not clear that it either should or does have significant operational content. I think it is convenient, very often, for people to justify what they do for other reasons, in terms of Libor, but it is not a rate at which anyone is actually borrowing. It is hard to see how it can actually have much of an impact. There is no doubt that what it is representing is the widespread loss of confidence in the financial community at large—not just banks but the financial community at large—in banks, as such. Eighteen months ago it was quite normal for anybody, including companies, to be willing to lend to a bank unsecured for three months at a very tiny margin over Bank Rate, because it was felt unthinkable that this was a risky loan. The world has changed totally; people are very worried about lending, and indeed hardly anybody is willing to lend to any bank around the world for three months unsecured; they want to lend secured. As I have said to the Committee before, I think that in future we will see far less lending to banks on an unsecured basis and far more on a secured basis. The inter-bank market has very often been a market in which overnight or short-term cash holdings can be distributed around the banking system, and banks were willing to do it with each other unsecured at Libor. I just do not think it plays that role now, and I think we are going to see developing over the next few years a much more intensive method in which banks can redistribute cash surpluses and shortages among each other on a more secured basis. At present they are doing it directly with the central bank, and that is true around the world, not just in the UK.

  Chairman: So there is more to it than meets the eye. We look forward to your comprehensive note. That was a great primer. Thank you.

  Q35  Sir Peter Viggers: May I return to the point of fiscal stimulus? You have been completely consistent in saying that fiscal stimulus could be justified if it is temporary ("strictly temporary", to quote you, Governor) and that tax and spending come back into a sustainable balance over the medium term. The Government's proposals will bring the tax and spending back into a sustainable balance in 2015-2016, which is after the election after next. That is even on their optimistic assumptions. Are you saying that that is temporary, or have you changed your mind?

  Mr King: No, the measures that are being taken to stimulate activity are temporary. I have said there were two conditions: that the measures be temporary (they are temporary) and, secondly, that there was a path back to fiscal sustainability. As you rightly point out, that path is long and hard and the implied ratio of debt to national income only starts falling in 2015-2016, which is a very long way away. That is an indication of how serious the fiscal position is at present.

  Q36  John Thurso: Governor, as you said, the most pressing thing is to ensure that normal bank lending is resumed, and you have given a very full answer to the Chairman and Mr Ainger. Can I press you on just one point on that? A number of the bankers that I have spoken to seem to think that having passed Go and got the £500 billion it is business as usual and they do not need to worry too much, and heads down and they will soon be kind of all right. Should not the Government, or the Bank, or somebody, actually produce a memorandum of understanding or a concordat—something—that actually sets out clearly the principles? We seem to have a divergence of view between the bankers, who kind of are going: "Phew! Thank you very much, now let's get on with life", and all the rest of us who are saying: "We're giving you the money for a purpose."

  Mr King: I do not think I know many bankers who think it is sort of "business as usual" or that they are saying: "Phew!" The reason is because they have been given massive amounts of public support. You are absolutely right; hundreds of billions of taxpayers' money has been lent to the banks. However, it has only been lent to the banks, and they are going to have to repay it. The problem facing the banks is that they feel under enormous pressure now; having gone through a long period in which the amount of money they borrowed grew very rapidly, they now realise that their gearing ratios and leverage was much too high and they are under enormous pressure to reduce it—this is pressure coming from the market—because if they do not take steps to reduce it their share price falls. So one can understand why the banks individually think that it is in their interests financially to reduce lending to reduce the size of their balance sheet. Collectively, of course, I do not think this does make sense because they are merely exacerbating the downturn which will increase their own losses in the future and damage their underlying capital position. So there is, I think, a real chance here to bring the banks together in order to say: "Look, how can we, collectively, get out of this?" I do not think it is in the banks' collective interest that we go into a deep recession or downturn. However, individually, I think one can understand the pressures that they are under. The recapitalisation has certainly eased those pressures and it prevented the banks from failing, which is where they would otherwise have been, but it has not got them yet to a position where they feel confident enough to resume lending. We have to get to that point, and if it means some kind of concordat, so be it. One way or another we have to find a means to get the banking system to resume lending. I do not think, at this stage, I want to rule anything out, though I do think there is a sequence to start here, and the first thing is to start with more intensive monitoring and then discussions with the banks.

  Q37  John Thurso: It does seem to me, Governor, that—and you quite rightly make a difference between what is in the interests of an individual bank and what the collective system requires, which appears to be diametrically opposite at the moment—without some form of formal concordat or MOU or something that lays out the principles (not telling how the bank has to run its business but lays out the principles), then there is nothing for the individual institution to be guided by. It seemed to me it was a pretty strong need to arrive where you want to arrive.

  Mr King: I do not want to prejudge what is the right way through this. What you say may well turn out to be necessary. I think we should, first of all, find out what answers the banks have as to how we are going to get through this, and then see. I certainly do not rule out the approach that you suggest.

  Q38  John Thurso: Can I turn to another point you made in your opening statement, which is the impact of Lehman Brothers and the destabilising factor that that was. With the benefit of hindsight, do you think Lehman Brothers was actually a systemic risk and was too large to have been allowed to fail?

  Mr King: I think with the benefit of hindsight it was clear that after Lehman Brothers failed the sequence of events occurred which led to the collapse of confidence in the banking and wider financial system that has proved deeply damaging. I do not think it was inevitable that that happened. I do not think questions of confidence are ever questions of inevitability, but it happens. I just do not think it makes sense to blame the US authorities for that; I do not think they could easily have known, nor did many people say so immediately—and they did not have any powers. In fact, one of the most interesting things about the experience was how many of my colleagues in the United States said: "Now I realise why you, the UK, have been talking about having proper powers to deal with banks", because Lehman Brothers was not a deposit-taking institution, it did not come under the FDIC and they did not have the powers to deal with it as they would have been able to do with a deposit-taking institution. They will obviously want to look at that in the future. Be that as it may, we are where we are, Lehman Brothers did fail and it did lead to a quite extraordinary sequence of events, which has led to the biggest banks in the world getting to the point of virtual collapse. I do not think anyone had anticipated that that was likely, or even remotely likely, to happen. It is something that people thought was associated with reading about the financial history of the 19th Century. However, it happened and we have to confront the circumstances and find a way through it.

  Q39  John Thurso: You make an interesting point about their not having the powers. In this country do you feel that we have the appropriate powers if, God forbid, anything similar were to happen?

  Mr King: We will have, I hope, thanks to all of you voting through—

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