By John Kay
Published: November 25 2008 19:32 Last updated: November 25 2008 19:32
Governments of the world are becoming major shareholders in their financial institutions. The British government owns two mortgage lenders – Bradford & Bingley and Northern Rock – is likely soon to hold a majority of the capital of the Royal Bank of Scotland, and to be much the largest shareholder in the combined HBOS/Lloyds TSB. The US government has a dominant holding in AIG, one of the world’s largest insurers, and will soon hold a similar position in Citigroup, making it the biggest financial institution of all. Fortis and ABN Amro are owned by Benelux governments. And so on.
Early socialists must be chuckling in their graves. But this government control of the commanding heights does not represent the triumph of socialism over capitalism, but the necessity of pragmatism in the face of failures of capitalism. Governments do not want to own these stakes, and are not quite sure what to do with them.
Nationalised financial institutions have often been badly run businesses which served neither their owners nor their customers well. But recent experience has shown that privately owned financial institutions have often been badly run businesses which served neither their owners nor their customers well. One might argue that the private businesses served their customers better than their owners; while the state-owned ones served their owners better than their customers. Such are the inherent contradictions of capitalism, as Marx would have put it.
The British government has perhaps the clearest strategy. It has set up an organisation called UK Financial Investments. The intention is that UKFI should act as a relatively passive shareholder in these businesses with a view to a quick realisation. UKFI is modelled on the Shareholder Executive established five years ago to hold government stakes in other companies. The reports of the Shareholder Executive read rather like the updates a private equity house might prepare for investors.
But this answer is not adequate. The problems are evident in these reports from the Shareholder Executive. The government owns businesses such as Royal Mail and the Nuclear Decommissioning Authority for a reason. The rationale of public ownership is that there is a strong public interest, not just in the financial returns from these activities, but in what these businesses do and how they operate. The government does not, cannot and should not have the same kind of relationship with the companies it owns as a private equity owner.
That does not mean that the Shareholder Executive is a bad idea. Officials in government departments are often ignorant and naïve when faced with issues that are the day-to-day concern of private equity professionals and investment bankers; their expertise needed reinforcement. But while the government has an interest as investor, that cannot be its only interest: if it were the only interest, then government should not be an investor at all.
So with banks. The government will not recapitalise Woolworths because it matters little to the wider economy whether or not Woolworths stays in business. The government does recapitalise banks because there is a vital public interest in the continued operation of the payment system and the availability of finance to small- and medium-size businesses. So the primary purpose of the investment is not to ensure that the taxpayer gets its money back – although that issue should certainly not be neglected – but to ensure that these ordinary banking functions operate well.
But no one who talks to small business owners today can believe that that objective is being met. If it was much too easy to get loans in the salad days, it is much too difficult to get them in the locust years. The consequences of the loan restrictions are plunging the non-financial economy into depression. If there are concerns over the availability of mortgage finance – and there should be – then it is absurd to run down the very efficient mortgage administration activities of the two mortgage banks the British government owns. We taxpayers have rescued these financial institutions for a specific purpose, and we should use our stakes in them to insist that this purpose is fulfilled.
Darling’s Christmas present conceals a debt trap
By Simon Ward
Published: November 25 2008 20:02 Last updated: November 25 2008 20:02
Alistair Darling’s emergency Budget is pregnant with dangers. It will not achieve his objectives of shortening the recession and hastening recovery while the borrowing the UK will have to undertake will impose major costs on future taxpayers, endangering the long-term health of the economy.
On the face of it, Mr Darling is delivering a significant economic stimulus in 2009-10 through his temporary VAT cut and other measures. The Treasury reckons cyclically adjusted net borrowing will rise by 1.9 percentage points of gross domestic product, the largest increase since 1992-93. This will contribute to record headline borrowing of £118bn in 2009-10 or 8 per cent of GDP.
The form of the package and its temporary nature, however, imply a much smaller impact on demand. Most consumers base their spending on long-term income expectations. Current income is a key factor only for families with no savings or credit. A temporary tax cut applied across all families paid for by higher future taxes may not have a significant impact on consumption. Measures targeted at savings-short, credit-constrained people would have a greater chance of success, but the rise in spending would be partly offset by cutbacks by others anticipating lower future post-tax incomes.
Fiscal actions financed by higher borrowing can deliver a short-term stimulus. Policies must, however, be designed to enhance the economy’s long-term supply potential, thereby raising long-term income expectations. Examples include marginal tax rate cuts, which stimulate entrepreneurship and effort, and public investment in projects promising high returns such as transport infrastructure.
A temporary VAT cut is not targeted at people more likely to spend any gains and has no positive impact on the economy’s long-term supply potential. Consumption will rise in the months before the lower rate is withdrawn but fall by roughly the same extent afterwards. The temporarily higher demand will be met either from imports or a rundown of stocks, with no impact on domestic production.
Higher borrowing can have monetary effects; a rising deficit financed by bank borrowing rather than bond sales would boost the money supply, representing a “net injection of cash to the economy”. The same positive monetary impact, however, could be achieved simply by “underfunding” the existing deficit, without further fiscal largesse. The authorities appear to have rejected underfunding as an option.
Regardless of whether the effect of Darling’s package is large or small, it will be fully reversed in 2010-11 and beyond as the VAT cut is reversed and higher national insurance and income taxes kick in. Cyclically adjusted net borrowing is projected to fall by a combined 2.9 percentage points of GDP in 2010-11 and 2011-12. This could undercut the Treasury’s hopes of GDP growth of 2 per cent and 3 per cent respectively in these two years.
So it is possible that by 2011 the economy will be no stronger than in the absence of Mr Darling’s measures yet the public finances will be worse, with the net debt/GDP ratio on the Treasury’s own optimistic projections reaching 53 per cent by March 2011, even excluding the impact of recent financial sector rescues.
Servicing this debt will eat significantly into the nation’s resources. The Treasury projects a rise in debt interest from 1.7 percentage points of GDP in 2008-09 to 2.4 percentage points by 2013-14. This increase is the equivalent of £10bn in today’s prices. Put another way, the increased cost equals a 2.5p rise in basic rate income tax.
Even this could be too optimistic. The Treasury assumes the interest rate paid on debt averages 0.9 percentage points less than the annual GDP growth rate in nominal terms between 2010-11 and 2013-14. Investors may, however, demand higher yields to induce them to hold more gilts. If the average interest rate were to equal nominal GDP growth, debt interest would soar to more than 3 per cent of GDP by 2013-14.
The danger is of a debt trap – a vicious circle in which the debt/GDP ratio explodes as rising debt interest causes ever widening budget deficits. A debt trap develops if two conditions are fulfilled – the primary budget balance, which excludes debt interest, is in deficit, and the debt interest rate is greater than money GDP growth. The Treasury’s forecasts show an average primary deficit of 3.3 per cent of GDP over the next five fiscal years. Even a modest rise in gilt yields would cause the debt/GDP ratio to explode.
The writer is New Star Asset Management’s economist and strategist
Copyright The Financial Times Limited 2008