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.

Whitehall's Magic Money Roundabout

Ever seen a Whitehall Farce? Typically these knockabout romps involved at least one trouserless character being pursued offstage while his double immaculately appears from opposite stage to replace him. Farces at the Whitehall Theatre in Westminster ceased in the 1960s. But over at the Treasury they seem to be carrying on the tradition with gusto.

To get our facts clear: the Treasury is the body responsible for issuing government gilts. These are long-term IOUs that help the government pay the nation's bills.

Now, we know that thanks to quantitative easing (QE), Gordon's magic answer to the money shortage in our banks, the Bank of England is aggressively buying back gilts and bonds in order to issue its freshly printed money.

Not only does this increase the national money supply it also lowers long-term interest rates, both of which (other serious consequences notwithstanding) appear presently as good things for our broad economy.

But, hey, what about all those massive government debts? The hundreds of billions of pounds already handed to the banks? The hundreds of billions more guaranteeing their toxic assets? And the hundreds of billions needed to provide the public services? That's right, the government needs to borrow a great deal more. A very, very great deal more.

So what are they doing about this over at the Treasury? Well naturally, they're issuing bundles more government gilts! Which, if I have this right, is the direct opposite of the Bank's policy.

Uh... It makes you scratch you're head, doesn't it? But then you realise this is merely reviving a uniquely British tradition (last seen during Harold Wilson's confused swinging Britain).

The Whitehall Farces carry on starring Gordon, Alistair and Mervyn.

Magic Money Roundabout – The Gilts and Bondage Season

Programme: Mondays, Wednesdays and Fridays... 'No Gilts Please, We're British'
Tuesdays and Thursdays... 'Gilts Away'

So have you bought your tickets yet? Or are you selling?

Q&E – but where are the slumdog millionaires?

I am not a professional economist. And my early banking career was very short-lived. Does this explain my lack of confidence in today's Bank of England's decision to cut interest rates by another half percent and ALSO announce a programme of quantitative easing (QE)?

What is the Bank / government trying to achieve? Obviously, it is trying to re-stimulate lending by our banks in the hope that this will kick-start economic activity.

But pardon me for making this observation. While there may be many businesses being harshly treated by their banks (by restricting reasonable access to cash flow), there are many more with turnover that has dramatically declined who can't reasonably expect banks to provide credit on previous business terms, if at all. It's not reasonable for banks to substitute lost turnover with loans when there's no expectation of an end to the current depression.

Businesses do not exist in a world of their own, able to expand and flourish as long as they can borrow money. Businesses need customers, who are both able and willing to spend. For the foreseeable future, the public will not be entertaining any spending sprees. They face unemployment, crashing housing assets and their government (without formal request) has purloined several trillion pounds of their future earnings, which at some future date must surely be paid up.

Mervyn King probably does get this. Last month, heralding future QE, he said, "the balance of risks to the path for GDP is very much to the downside, reflecting in large part uncertainty about when lending and confidence will recover".

In other words, even if introducing quantitative easing does reduce long-term borrowing rates, restoring economic confidence may be a separate issue altogether.