Monday, 21 February 2011

Merlin and the Once and Future crisis - or why this science is dismal

A lot has been made in the past week of project Merlin and the efficacy and seriousness of the government's negotiation with the banks. The main thing that struck me, leaving aside for the moment the Big Society bank and all that two of those words entail, is this repeated emphasis on "getting the banks to start lending again" which has been recycled over and over during the past year.

Obviously this like many other things is repeated so often because it is a set of talking points for the government, it represents them getting something out of the banks, and suggests a plan for growth and support for small businesses. So what  does it mean in practical terms? As best I understand it there are two substantive sides to this issue:

First there is the inherent conflict between repairing the balance sheets of the banks and increasing lending to credit-worthy smaller companies( the larger firms tend to do fine except in crisis situations because it is far easier to predict their short term chances of success, and they may have larger cash reserves and more room to cut costs than a small firm, which is inherently a greater risk to a potential creditor.) The government famously had to bail out the banks at the height of the crisis and in order to sell them back to the private sector at a profit it first has to make them safe again, and this means building up reserves.

Among the ways banks can build up reserves are to lend less, and to charge higher rates of interest. Neither of these is particularly good news for the economy, and so the government has a habit of talking about "getting the banks to lend" without actually taking any concrete action. The Merlin figures are effectively non-binding, and have no legal character to them, even though the government owns very large stakes in some of the largest banks, it is far from clear that they will actually enforce that part of the agreement.

The second problem is that banks don't just lend less in order to accumulate cash, they also see fewer viable investments out there. The reason for this is that overall demand in the economy has decreased, and so small companies are less likely to find a market for their goods and services. Unemployment has risen sharply since the crisis, while wages are depressed (as are wage earners), and the result is that people are buying a lot less.

Growth in the British economy slowed progressively as 2010 wore on, finally becoming negative in the last quarter, and, the harsh winter notwithstanding, this was part of a clear trend towards diminishing growth. It seems likely that as the cuts were announced businesses and private individuals cut back in order to prepare for the age of austerity. Meanwhile, inflation has been consistently high, in part because of the low interest rates maintained by the bank of England and the devaluation of the sterling but also significantly driven by external factors. In short, purchasing power has fallen, unemployment has risen and GDP has floundered.

In this atmosphere, and with the cuts yet to take effect, it is unlikely that-- whatever their commitments under project Merlin-- the banks will increase lending in 2011. They will judge, perhaps quite rightly, that the risks outweigh the benefits. This decreased availability of credit will reduce the available cash for investment and consumption, and will add to the problems besetting the economy. The clear conclusion is that things may get much worse, and further GDP decline will increase the debt to GDP ratio and reduce tax receipts. The UK is not Ireland, but the senior members of the coalition have taken pains in the past to express their admiration for the Irish model.

But then, in the end Merlin was cast down by his own magic.

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