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When it comes to economic recovery, where do the problems lie– with the Bank of England or the Government?

The recent attack by Vince Cable, the Secretary of State for Business, Innovation and Skills, who was quoted referring to the Bank of England as the ‘capital Taliban’ in a recent Financial Times article, has attracted attention because of its colourful language. It also appears to represent a widespread sense of frustration being felt by other members of the Cabinet, including the Chancellor of the Exchequer, that the Bank of England’s regulators are undermining the wider economic recovery by their control-freak approach. This concern is one of the main themes of Politeia’s new pamphlet The Financial sector and the UK Economy: The Danger of Over Regulation, of which I am a co-author.

The main difference between Dr Cable’s complaint and the views expressed in the Politeia pamphlet is that Dr Cable was concentrating on one specific symptom of the problem of excessive financial regulation – the difficulty of small businesses gaining access to credit – whereas the authors of the pamphlet were concerned with the system as a whole, including the effects of regulation on the supplies of broad money and credit, and the effects of the money and credit supplies on the wider economy.

As far as small businesses are concerned, some two thirds appear to have more money on deposit than they have bank loans. Indeed, many successful small businesses tend to have a policy of never using bank finance; these also tend to be the ones that survive across several generations. In addition, an overbearing state causes many other difficulties including administrative and compliance costs. One small business federation has claimed that its average member spends 35 hours a month – i.e. a full working week – coping with state-imposed administrative burdens, such as VAT returns etc.

In addition, the main business killer in a recession is fixed costs that the proprietor can do nothing to reduce, without closing down entirely. The main example here is business rates, which have to be paid regardless of the owner’s financial circumstances. Another problem is the UK tradition of upwards only rent reviews, which again prevents the property market clearing in a recession, when property values are being reduced. Business rates and upwards only rent reviews are a major reason why so many UK high streets are now chock-a-block with empty properties. Without these impediments, the costs of leasing properties would fall to the point where small entrepreneurs with limited capital resources would flood in to take advantage of the availability of cheap rentals, and the high street would bloom again. One factor behind the recent spectacular bankruptcy of the US city of Detroit is that the property tax there was twice the US national average, encouraging capital flight and the collapse of the tax base.

In summary, Dr Cable was right to criticise the Bank of England for being excessively rigid in its approach, for reasons independently set out by several authors to The Financial Sector and the UK Economy. However his concentration on the damage being done to small businesses specifically, masked the fact that this was just one facet of a far wider problem. Most small businesses do not rely on bank credit and are probably wise to do so. Entrepreneurs with a ‘brilliant idea’ are notoriously over-optimistic about their chances of success, possibly two thirds will have failed within a couple of years. The first duty of commercial banks is to protect the interest of their depositors and therefore not risk large scale bad debts, even in order to placate politicians. A programme to encourage small businesses is certainly highly desirable. However, this should concentrate on the real supply side issues, including regulatory and compliance costs and fixed impositions such as the business rate at which take no account of ability to pay.

Here, as elsewhere, there is a serious problem of policy inconsistency involved. HMG itself has been a major party to the regulatory overdrive – including the requirement for capital ratios – which have taken their toll on banks’ ability or willingness to lend. At the same time, as their objective measures have made balance sheet retrenchment the only reasonable option for the banks, politicians have criticised bankers for not lending more. In the longer term, of course, faster economic growth in the economy’s non-socialised sector requires a comprehensive package of supply side friendly reforms – i.e, lower taxes on productive borrowing and a bonfire of excessive regulatory controls. It is the coalition’s failure here which explains why the recovery has been so sluggish, and long-term growth will remain poor, even if the monetary authorities do whip up a transitory demand-led boom in the very short term.

One final point is that one reason the recent imposition of the 3% leverage ratio on UK financial institutions has caused such annoyance is that it was added at a late stage to the Basle agreement capital requirements, which applied risk weightings to specific classes of loan and discriminated against small businesses because they were perceived of as high risk – quite unlike Greek government bonds, for example. The sudden introduction of the new leverage ratio has correspondingly hit institutions such as Nationwide, whose balance sheet was predominantly low-risk mortgages, disproportionately hard. One can well understand the fury of commercial bank executives who found that the regulators had suddenly changed the rules of the game half way through after they had spent much trouble and expense complying with an earlier set of regulations. However, the proposed leverage ratio does have the advantage that it is simple and robust and does not discriminate between different types of borrower, which is something best left to the commercial judgement of the lending organisation concerned.

Replacing all the complex Basle capital requirements with a simple leverage ratio would represent a liberalising measure in a free-market direction. However, there is no case for having a multiplicity of mutually inconsistent constraints being placed on the balance sheets of financial institutions and even less justification for regulators to change the rules of the game in mid play.

*David B Smith is Visiting Professor, Derby Business School, the Chairman of the IEA’s Shadow Monetary Policy Committee. He is the author of ‘Financial Regulation and the Wider Economy: Unintended Consequences’ in Politeia’s new publication The Financial sector and the UK Economy: The Danger of Over Regulation.

David B. Smith

David B. Smith is a City economist who worked as a macroeconomic modeller and economic forecaster, predominantly in banks (including the Bank of England) and security houses (1968-2006). He maintains his own macroeconomic forecasting model at Beacon Economic Forecasting. His Politeia publications include Britain's Taxable Capacity: Has it Reached the Upper Limit? (2020), The Brexit Settlement and UK Taxes (2018) and Banking on Recovery: Towards an accountable, stable financial sector (as co-author, 2016).

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