King: 'no recovery till banks raise capital'
The governor of the Bank of England has given his starkest warning that banks in what he calls the advanced economies, including British banks, still have too little capital to absorb potential losses on bad loans. And he says that the economy will remain weak till they raise the needed capital.
Sir Mervyn King also made clear that he is implacably opposed to what has become known as "helicopter money", or the creation of new money by the Bank of England for writing off government debt, or funding tax cuts, or paying for public spending.
Although there is likely to be confirmation later this week that the UK economy is out of recession, the recovery remains anaemic, some four years after the great banking crisis that undermined global growth.
Sir Mervyn pointed out that the output of the British economy, or GDP, is 15% less than what it would have been if growth had been steady since 2007 - which (to simplify) implies that our incomes are 15% less than they would and should have been in the absence of the great financial shock of four years ago.
There has therefore been a great deal of agonising by those in positions to influence the economy, such as the chancellor, the chairman of the Financial Services Authority and the governor, about how economic momentum can be restored.
In a speech on Tuesday evening in Cardiff, Sir Mervyn makes two striking points about possible remedies.
First he says that the reason banks, including some British banks, have found it difficult and expensive to borrow, and therefore have found it impossible to provide the credit needed by households and businesses, in the right quantities and at the right price, is that they have "insufficient capital".
Sir Mervyn warns that "just as in 2008, there is a deep reluctance to admit the extent of the under-capitalisation of the banking system in many parts of the industrialised world".
The Bank of England has applied some sticking plaster to British banks, by launching two schemes - Funding for Lending and the Extended Collateral Term Repo - which are designed to provide cheap finance to banks, to compensate for investors reluctance to lend to banks.
But he says that Funding for Lending can be "only a temporary scheme". And he insists that the "window of opportunity it provides must be used to restore the capital position of the UK banking system".
Here is his stark and gloomy warning: "I am not sure that advanced economies in general will find it easy to get out of their current predicament without creditors acknowledging further likely losses, a significant writing down of asset values and recapitalisation of their financial systems."
He continues: "Only then will it be possible to return to a more normal provision of vital banking services so crucial to an economic recovery".
Sir Mervyn is fearful that we will repeat the mistakes of the 1930s in hoping that borrowers struggling to keep up the payments will one day be in a position to repay what they owe. Far better, he says, to turn off the life support for over-indebted businesses, households and even governments, write off the debts and start again.
Or to put it another way, the socially responsible behaviour of British banks in engaging in what is known as forbearance, by allowing overstretched debtors to take a holiday on payments, may now have become a burden on the economy as a whole - by keeping the banks in a state of permanent anxiety that one day they will incur huge losses on loans to these debtors.
Forcing our big banks to recognise all the big losses they are likely to face and raise enough capital to absorb those losses is the sine qua non, he says, of restoring the health of our banks so that they can provide the credit we need.
However, if that is Sir Mervyn's prescription for a sustainable economic recovery, he is scathing about those who argue that the Bank should write off some or all of the £375bn it is owed by the government, or should simply give money to the government to finance the gap between what the public sector spends and what it raises in taxes.
Both of these unconventional monetary policies are variations of the creation of "helicopter money" - which is styled in that way because economists see them as the equivalent of dropping free cash on all of us from a helicopter.
Sir Mervyn sees three fundamental reasons for eschewing helicopter money.
First, he says that if the Bank of England were to write off the gilts it has bought through quantitative easing, and thus cancels what the government owes, the Bank will have no gilts to sell to investors at the very moment when it may want to nudge up bond interest rates, and take the heat out of any incipient inflationary conditions.
Second, writing off these gilts would also leave the Bank of England with no income with which to pay commercial banks the interest they are due on their deposits at the Bank.
So at a time when the Bank wanted to push up the bank rate or interest rate on these "reserves" to stem inflation, the Bank would face a stark choice: it could become insolvent (which, to state the bloomin' obvious, would not be good); or it could create yet more new money to pay the interest to banks, which would be seen as debasing the value of sterling in a fundamental way, and could lead to hyper inflation.
Sir Mervyn says: "That is a road down which the Bank will not go and does not need to go".
For what it is worth, some may well see Sir Mervyn's attack on helicopter money as an attack on a candidate to succeed him as governor, Lord Turner, currently chairman of the Financial Services Authority.
But that is probably not quite right, because - as Sir Mervyn will know - while Lord Turner does believe that helicopter money is one of a number of unconventional policies that the authorities should consider, in the event that the economy doesn't recover, he has not made up his mind that helicopter money will turn out to be necessary.