Saturday, 14 March 2009

Lessons for Gordon from over the pond

I've been casting an eye over the thoughts of an American commentator on government econo-political policy. His name is Lawrence Kudlow and I've no idea in what respect he is held, but this is a gist of what he currently has to say.

Apparently, in the run up to the bank credit crisis in the US, the Treasury yield curve was in negative territory.

OK, I'll try to explain that.

When the Treasury has a policy of tight money then interest rates are set relatively high. In 2006-7 in the US, such a Treasury policy had the effect of pushing short-term borrowing rates above long-term rates – producing negative yields for the banking industry. This is because banks borrow short and lend long to make money profitably. Kudlow believes the negative interest margins experienced by US banks in this period were a significant factor in creating the credit crunch.

Be that contention as it may, Kudlow has noticed a considerably different environment now the US Treasury (as in other countries) is pushing cheap short-term money. US bank stocks have rallied this past week, showing 40% gains on US financial markets. This follows several US banks stating they will post handsome profits on business conducted during the first quarter of this year.

As Kudlow has it, this is an effect of the now positive bankers' yield curve. And who would argue that Treasury / central bank policy around much of the world – of dramatically dropping official interest rates – is intended precisely to encourage banks to lend again? And who would argue that obtaining virtually free money is a positive incentive for banks to lend on at higher borrower rates?

So much for Kudlow's observations. Now I turn to the situation we have in the UK.

In contrast to the US, we have a very small - and reducing - number of banks. Their toxic debts, relative to the economy, are large. And their paranoia about engaging in further business risk is great. They are proving obstinate over returning to lending mode, despite short-term capital available at 0.5% and lorry loads of government/taxpayer underwriting of their past indiscretions.

My personal belief is they are reluctant to lend because they can see the economy going bad, not least because of the way the government has reacted to the banks' own predicament.

Nevertheless, a positive up-sloping yield curve is the best business proposition our banks are likely to get. (Especially now other forms of profit engineering are 'out of favour'.) Yet what is the policy on which Magic Gordon has now bet the taxpayers' pension?

Yes, it's Quantitative Easing no less. The one policy that's guaranteed to reduce long-term interest rates.

Even as the policy was being announced, it's potential impact was being reflected on long-term financial markets. Long-term rates have begun to fall dramatically, and may continue to do so, as the Bank – on Gordon's orders – pumps £75 billion or £150 billion of electronic money into buying long-term bonds and gilts.

It's not quite negative yield territory. But the flattening yield curve considerably reduces the profit incentive banks may have to engage in Brown's sought after '2007 lending levels'.

Confused? Yes, that's as good a description as any of current policy. Look out for loads of kitchen sinks flooding the market, marked HMT.

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