23 May 2009

The government to the rescue?

The UK financial system was bailed out by the taxpayer to the tune of £500bn in 2008. Economics Editor Faisal Islam analyses the government’s response as it pumped billions of pounds into the city.

As part of the government’s rescue plan, the Bank of England would pump billions of pounds into the city to try and help stimulate lending again – the economic policy never tried before in Britain was to be known as quantitative easing.

It would see an initial £75bn injected into the banking sector, but the sum would eventually double as the economy failed to respond.

Essentially the policy involved the government printing new money. It was the biggest and most dramatic measure taken by the government during the economic disaster and a recognition that so far all other measures had failed.

The man who would mastermind the policy was Bank of England Governor Mervyn King. He was given the task to make it work.

Successful companies who had created hundreds of jobs, but relied on buying stocks months in advance, needed their banks to give the credit to cover those orders. That had become the problem with banks reluctant to lend following the economic crisis.

Laura Tenison, managing director of JoJo Maman Bebe told Channel 4 News: “When the credit crunch hit rather dramatically towards the end of August, we were told that actually the bank was no longer prepared to underwrite our forward purchasing.

“In effect, underwriting our letters of credit to our manufacturers in the Far East. This meant that we had to find new ways of funding or buying.”

For this company and thousands of others the problem is not the level of interest rates, instead the basic machinery of the financial system had ground to a halt.

How does quantitative easing help?

  • The Bank of England will buy government and company bonds from the banks and other financial institutions. Giving banks cash in return.
  • This money would go directly into the accounts they hold in the Bank of England.
  • The theory is that banks would then be more willing to lend that cash to consumers and businesses.
  • The government authorised up to £150bn to be pumped in by the Bank of England, if needed.

Former Chancellor Alistair Darling told Channel 4 News: “I believe that it is necessary to take a range of measures to help people, to help businesses get through this recession, through to recovery.”

George Osborne, the then shadow chancellor said: “Well it’s a last resort when you’ve reached the end of the road and there aren’t other options and other policies like that temporary VAT cut, simply haven’t worked. But it’s also a leap in the dark that holds real risks for the future, real risks for inflation.”

Banking insiders said there was no real limit to quantitative easing. Money could be used to buy any asset in Britain – shares, even houses.

In an interview with Channel 4 News the Governor of the Bank of England Mervyn King said: “Any policy measure has a high degree of uncertainty. I believe these measures will work, but I can’t tell you exactly when. Or indeed the scale of the purchases we may need to carry out in order to achieve our objective.

“But our objective is clear – it’s to see an increase in the supply of money in the economy; that we can see a level of spending return and a beginning to economic recovery in this country.”

The risks to quantitative easing were all too stark. Former monetary policy committee member Professor Charles Goodhart told Channel 4 News: “We’ve never done it before so we don’t know how much to do. So there’s a risk we might under do it and therefore not bring about the recovery.

“There’s a risk we might over do it and possibly won’t get a recovery that is so sharp. We’d actually get some inflationary tendencies. Then the Bank would have to reverse its policies very quickly.”

UK’s AAA rating in doubt

The UK has always had an AAA credit rating because British government bonds, known as gilts, were safe bets and the country always had a high standing in the economic world and fiscal stability. But on 21 May 2009, that was put in doubt.

Leading ratings agency, Standard and Poor’s started the process of downgrading the UK rating. It was all to do with the huge amount of debt being sold at the UK debt management office.

When a government spends more than it takes in taxes it has to borrow.

In an exclusive interview with Channel 4 News Robert Stheeman, the chief executive of the Debt Management Office, he said: “We are asked questions obviously about the direction and where things are going and it would be wrong to suggest otherwise, but at the same time a lot of the holdings come from highly sophisticated official institutions and they don’t seem to express undue concern or anything like that.”

The sums involved led economists to question whether the markets could absorb all the borrowing. Ten years ago the government needed to sell £10bn worth of gilt because the government finances were pretty much in balance.

Five years later they sold £52bn of government debt, because government borrowing had started to grow. In 2009 it had to find buyers for £220bn worth of government debt and in the coming four years it had to sell a further £700bn worth of gilt.

Mike Veissid of Spink Auctioneers told Channel 4 News: “Britain’s always paid its debt. The face value of the bonds is always quite high so people are very careful with them. They’ve all been repaid and the certificates destroyed – unlike countries like China and Russia where they defaulted.”

The bond markets determine the fate of nations, their state in the world and their solvency. According to one financier, Britain’s financial reputation is up for debate.

Jim Rogers told Channel 4 News: “I’m not saying that Britain is like Iceland at the moment. But if things do begin to deteriorate downward there will become a time when people say ‘I’m not going to lend money to the UK anymore’.”

Standard and Poor’s said there was more than a one in three chance of Britain following Ireland and Spain and being stripped of its AAA rating, something the Debt Management Office chief played down.

Robert Stheeman said: “The credit rating is just that, it’s an opinion by the credit rating agencies. I don’t think it would fundamentally change the way investors internationally view our debt. Could it mean that they actually demand fractionally more in terms of yields? Probably yes.

“But I think it’s much more to be expressed in price than anything else, it could easily be quite imperceptible.”