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Keep Calm and Carry on

Financial markets have continued to be dysfunctional. But to loose our nerve would be a mistake, argues Stephen Beer.

A friend gave me recently a copy of a Second World War poster he thought might be encouraging in these uncertain times.  In large white letters on an appropriately red background, it declares we should ‘KEEP CALM AND CARRY ON’.  The poster was never used because it was held back for display in the event of invasion or gas attack.  That rather puts the travails of the present day into perspective.  Still, the message is relevant.

Financial markets have continued to be dysfunctional.  Banks have to borrow money at rates well above the Bank of England base rate and markets in many securities remain effectively closed.  The greed and enthusiasm of twelve months ago have given way to fear and despair.  Banks are still writing off exposure to securities linked to the US sub prime mortgage market worth billions of dollars.  At the end of March, the FTSE All Share index was off 16% from its high in June last year.

In times of financial crisis a finance minister has a number of tasks.  The first is to deal with the current situation to stop it getting any worse.  The second is to anticipate any further immediate surprises markets might spring.  There will also be a natural desire to take action to prevent a similar crisis from recurring.  The minister will find it much easier to propose measures to address the latter problem than the first two.  Finally, the degree of any economic fallout has to be assessed and a judgement made about how fiscal or monetary policy should change.  It is on this area that economics and politics particularly converge.

Following the Federal Reserve’s lead, central banks are doing their best to supply liquidity to money markets and shore up confidence in the financial system.  Government mortgage institutions in the United States have been given more freedom to help the housing market.

Some believe there is more bad news ahead.  Both John Moulton of the private equity firm Alchemy and famous hedge fund manager George Soros are warning that the market in credit default swaps may spring surprises.  The market in these derivatives, effectively insurance against a bank or company defaulting on a bond, is immature and not transparent.  Holders of some credit default swaps do not know for sure if their counterparties will be able to pay out if necessary.  Here in some minds lies a financial abyss.  Soros believes it was exposure to these instruments that led to the Federal Reserve’s bail out of US investment bank Bear Sterns.

Improved regulatory measures are being announced.  Inevitably, we hear the sound of stable doors being shut somewhat late in the day.  US Treasury Secretary Hank Poulson has announced measures to streamline US financial regulation with more powers for the US Federal Reserve.  The UK Treasury is proposing ‘cross border colleges’ that would monitor international financial institutions.  The G7 is looking this week at regulatory proposals.

Regulation has limits.  The liberal US economist JK Galbraith wrote that given human nature, market euphoria will reappear.  ‘Regulation outlawing financial incredulity or mass euphoria is not a practical possibility...The only remedy, in fact, is an enhanced scepticism that would resolutely associate too evident optimism with probable foolishness and that would not associate intelligence with the acquisition, the deployment, or, for that matter, the administration of large sums of money.’

Are there alternative measures available?  Crises will probably happen every decade or so.  Yet we have learned again that financial markets rely on state support and an effective socialisation of finance despite low taxes.  We should now consider an additional ongoing tax for investment banks as an insurance payment for the inevitable bail-outs which the taxpayer will have to provide.

Galbraith linked financial crashes with Republican administrations.  He believed the prevailing political worldview has financial and economic implications.  This is a link we ignore today, despite the current woes and the warning that was Enron.

There should be no doubt there will be an impact on the economy.  Most political and financial leaders believe so, which is why they are expressing such confidence in the strength of our economies.  Last month, President Bush said that ‘In the long run, I'm confident that our economy will continue to grow, because the foundation is solid.’  He stands in the tradition of President Hoover.  During the 1929 stock market crash, Hoover was quoted as saying that the ‘fundamental business’ of the country was in good shape.  A member of his administration emphasised the ‘fundamental soundness of…economic activities.’ 

A rule of thumb is that a financial crisis will take around six months or so to impact company behaviour and the wider economy.  That has proved so in this case.  The US economy appears to be slowing with jobless claims on the rise.  In the UK, the Bank of England’s quarterly credit conditions survey last week showed lenders had reduced the availability of credit to households and companies since December.  Mortgage lenders have raised rates and tightened conditions.  These developments may herald a slowing to come.  There has yet to be an impact on employment or unemployment however.  It may be that one part of the economy – some houseowners for example – faces difficulties but that the economy continues to grow, at around half the rate of last year.  So it is important not to panic.

We should not blame our leaders for their confident statements, for confidence is what it is all about.  Economic transactions depend upon it.  Business investment will not increase with lower interest rates if confidence about the future ebbs away.  Households will spend less too.  The hope is that confidence will increase when financial markets stabilise and there could even be a surprise increase in economic growth later in the year.

Nevertheless, we should be prepared for tough economic times.  After the dotcom crash the UK economy was helped by increased government spending.  That is not happening now due to the fiscal rules.  This contrasts with the US, where President Bush introduced a fiscal stimulus package valued at £150bn, with tax cuts that Americans will notice from May.  Fiscal measures however have a mixed record in offsetting recessions, often because time lags mean the economy is in recovery by the time they take full effect.  They are most effective if used in a deep recession in Keynesian fashion, to compensate for a sustained fall in business investment caused by a drop in confidence.

With mortgage supply falling and house prices appearing to do similar, our politics on the economy must adjust.  A good start would be made by restating our economic policy clearly.  The ‘politics of aspiration’ now sounds tired and overused.  What matters is economic, social, and civic freedom.  Policies must recognise that people are harder up than they were a year ago.  Finally, it is not enough to get the policies right, whether for our core vote or ‘middle England’: we must return to a confident narrative about a society and economy in which every citizen has a valued stake and mutual responsibility.

Oh yes, and proud of our record in government and determined to do more, we should Keep Calm and Carry On.

This article previously appeared in Tribune magazine.
Stephen Beer, April 2008
Tribune April 08, 01/04/2008

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