Has Mervyn King put all his eggs into one basket?

Last week the Bank of England delivered its penultimate inflation report of the year. This is an important economic event for the UK - not only do we get the updated Bank of England forecasts for growth and inflation, but the Governor also holds a press conference and answers questions he is not prepped for.

This is always the most interesting part of the inflation report – when we get Mervyn King at his most candid. Usually the Governor stays close to his script, but at last week’s meeting King was more open than he has been in the past.

He said very bluntly that another rate cut would be fairly counter-productive at this stage of the UK’s economic cycle. Was that a tacit acknowledgement from Sir Mervyn that the BOE has done all it can and effectively run out of road in trying to help the UK through tough economic times?

The BOE can’t sort this crisis out by itself and instead has teamed up with the Treasury to launch the Funding for Lending Scheme (FLS) to try and boost lending to the economy.  Last week King almost admitted that the Bank’s next steps will be dependent on the success of this joint venture with the government. He ruled out the prospect of more BOE support, such as QE, until the results of FLS are known, which he thought may be in November.

If the Governor is pinning his hopes for the UK’s economic recovery on the FLS then that seems a good enough excuse to me to try and investigate what it is and how it works.

Essentially it works by giving banks access to borrow money directly from the Bank of England at super-cheap rates for up to four years. The banks need to post collateral to get the funds in the form of loans, mortgages etc - however, so far, it looks like a good deal. 

But there is a catch. To get their hands on this cheap money (interest is only 0.25%) they have to boost their lending to the wider economy through business loans and household mortgages. If they don’t increase the size of their loan books then they will be penalised and the interest rate on BOE funds will jump by 0.25% for each 1% drop in banks’ loan books.

The BOE and the government hope that banks won’t be able to resist all of this cheap money and since they need to post consumer and business loans as collateral to get their hands on the BOE cash they will increase the number of loans they make over the next 18 months (the term of the FLS). The plan is that all of these new business loans and cheap mortgages will boost growth in the economy.

There is no doubt that lending to the private sector has plunged in recent months. Lending has been falling since the collapse of Lehman Brothers in 2008, but the growth rate in new loans is negative, contracting at a 6.2% monthly rate in June, levels we have not seen since the early 1980’s. So there is a good business case for the FLS.

However, for some of you who have been following the financial crisis closely then you may be slightly confused by the mixed messages being given to banks in the UK. We got into this mess in the first place because banks started to make irresponsible loans up to 2008 and the start of the financial crisis. Banks stopped lending to try and heal themselves and now they are being blackmailed into lending once more.

This is one of the reasons that BOE Governor King may be too reliant on the FLS to sort out the UK’s problems. Firstly, banks have become more cautious. Bad loans nearly sent them out of business and even the allure of cheap money may not get them to sup at the devil’s cup this time around. So the banks’ risk management teams may not want to take a chance on an internet start-up that has a 90% chance of failing.

Likewise, if someone works in an industry that could struggle during the current economic downturn and threaten their future employment (which includes everything from manufacturing, finance and even the public sector) then a bank may not want to take the risk of giving that person a mortgage. So the BOE and the Treasury may be overestimating the banking sector’s demand for cheap money.

They might also be overestimating demand for debt. Growth is non-existent in the UK, our trade data highlights how weak our export markets are, some of our dear European neighbours are desperately trying to avoid bailouts, or in Greece’s case defaults and even Mervyn King said he was puzzled by the resilience of the labour market in the UK, suggesting that its recent strength could be fragile.

This backdrop could easily put people off starting a business and taking a risk on a new venture. It could also stop business owners from expanding their enterprises as they prefer to baton down the hatches and protect the businesses they have.

The other problem the FLS may face is mortgage applications. These days you often need a hefty chunk of a deposit to get a mortgage in the first place, especially if you want to buy somewhere in London. Young people who should be buying houses can’t afford to, plenty of young people don’t even have a job so becoming a home owner is way down their list of priorities. Thus, expecting mortgages to be sucked up is plain naïve in this environment.

The FLS may work for some people, but I can’t see it having much of an economic effect and certainly not by November as Mervyn King seemed to suggest. Thus, the BOE may have to start getting creative as, by (almost) his own admission, there is little the BOE can do with its current repertoire of tools.