A banking system so bankrupt, half of it had to be taken into state control. A regulatory system exposed as a shambles. Monetary policy in a state of confusion. And public finances shot to pieces. Take all those together and there can be little debate that the system Gordon Brown and his main adviser, Ed Balls, laid down for running the British economy in 1997 has been in ruins. If it was a house, it would have been condemned.
Amid the wreckage, the first signs of a debate about a new set of rules is emerging. The shadow chancellor, George Osborne, made an important start last week, questioning the relationship between the Bank of England and the Financial Services Authority (FSA), and the size and role of the banks. But the debate will have to go a lot further, and the policies will need to be more radical.
Let’s start with what went wrong. In truth, just about everything. Brown misunderstood the way the City needs to be regulated. He put too much faith in inflation-targeting. He allowed the banking system to run out of control. And he mismanaged public finances. The results are plain: the worst financial crisis of the major developed economies, and probably the longest and most painful recession as well. By now, just about everyone outside of the Downing Street bunker accepts that the system needs to change. But how? Here are four places we should start.
1. Let the MPC target prices
The Monetary Policy Committee (MPC), created by Brown in 1997, needs to target asset prices along with conventional measures of inflation. In retrospect, it clearly made a mistake in allowing house prices to run out of control. True, Mervyn King, the governor of the Bank of England, issued plenty of warnings. But, looking back, the MPC should have been steadily raising interest rates throughout 2004 and 2005 to whatever level was necessary to get house-price inflation back to zero. Sure, it would have been painful – but not nearly as painful as what we are experiencing now. We need to learn the lessons of that. If not, we are simply doomed to repeat the same mistakes.
2. Give a regulator real muscle
The FSA has failed. A zealously bureaucratic organisation, it focused relentlessly on petty rules rather than the big picture. So it has made it virtually impossible to open a bank account without producing birth certificates in triplicate for ancestors stretching back to 1700. But if you wanted to bankrupt the whole country, that was fine. In reality, splitting out financial supervision from the central bank was a bad decision. In a crisis, they are the same thing.
The central bank can’t stand by and watch a major bank collapse, as we discovered last autumn. But if it has responsibility, it should have power as well. The Bank of England should be handed back the final say over the regulation of the banking system. The small, petty rules should be ripped up and replaced with broad principles designed to protect the system as a whole. Banks are full of clever, hard-working people thinking of ways to blow up the system – only a regulator close to the pulse of the market can be fast and flexible enough to spot problems early enough. The Bank of England is the only body that can do that.
3. Devise a strategy for state banks
A clear strategy for the nationalised banking system should be set out. We don’t want to create the British Leyland of financial services, offering up the Morris Marina of accounts, and the Austin Princess of investments. The small state-controlled former building societies, such as Northern Rock, should re-mutualise. As soon as they are in decent shape, they should be handed back to their account holders (which would be a great way of increasing deposits – carpet-bagging in reverse). After all, the mutuals have done well, so why not create more of them? The two big state-controlled banks, Lloyds HBOS and RBS, should be split up: Lloyds back into Lloyds and HBOS and RBS into RBS and NatWest. By themselves, NatWest and Lloyds would do fine. HBOS could be re-mutualised as soon as possible, and RBS left to wither, as a warning to other banks. The important task is to create an open, competitive banking system – not one dominated by two nationalised giants.
4. Slash public spending
Public spending has to be bought under control. The ‘golden rule’ Brown created in 1997 to keep debt under control is a joke. A rule isn’t a rule when you change it every time it looks likely to be broken. The rule that Britain needs is that public spending should be capped at 40% of GDP over an economic cycle, which means it shouldn’t be any higher than 35% at the peak of a boom. All the evidence shows that once the state sector climbs above 40%, economic performance declines dramatically. The cuts needed to achieve that might be painful – but are surely preferable to years of French-style stagnation.
No doubt there will be plenty of other reforms needed as well. But a new inflation target, a re-regulated City, a slimmer, privatised banking system, and a shrinking public sector would give the British economy at least the chance of relatively quick recovery.