The banking crisis tells us it's time to buy gilts
We're in a solvency crisis, not a liquidity crisis, says James Ferguson. And in times like these, banks develop an appetite for risk-free assets - government bonds.
The decision to spend taxpayers' money to boost banks' balance sheets, and the 1.5% base-rate cut last month, show that the authorities now grasp what I've been saying all along. This is a solvency crisis, not just a liquidity crisis and it's across the board, not solely restricted to a few badly run banks.
And despite what looks like a worrying rise in debt, Alistair Darling's huge gilt-issuance plan suggests that the Treasury has been reading up on what a systemic banking crisis looks like. After all, it's not as if they're all that rare. The World Bank has identified 117 banking crises worldwide since the early 1970s (not including the recent rash, of course). The Bank of England itself has studied in detail 33 mainly first-world banking crises between 1977 and 2002. So they really should all know by now how such scenarios play out, despite Gordon Brown's attempts to portray himself as the only European politician with any idea of what policy to pursue next.
In short, a systemic banking crisis temporarily stops monetary policy from working. Whatever the central bank does to try to ease credit, banks are in no fit state to pass it on. Instead, they need to rebuild their balance sheets. On the one hand, that means boosting capital. On the other, it means 'de-risking' the profile of their assets. In other words, they have to cut back the riskiest loan and security assets on their balance sheets. So a decline in the amount of credit available is therefore the necessary, inevitable (and arguably desirable) consequence of 'saving' the banks with public money.
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When the government 'saves' a bank, it gives it cash so that it can still facilitate payments and trade and, hopefully, give credit to smaller firms for short-term cash-flow purposes. What it cannot save is the easy access to cheap long-term lending. Lending too much at low margins is what got the banks into today's mess in the first place. And things will get worse losses due to the deepening recession, and banks' attempts to shrink their loan books (driving the price of risky assets even lower), will only further erode their capital bases. Further government money will undoubtedly be needed.
There's a snag. It makes sense for each bank on its own to refuse to roll over, or even to call, risky loans. But when they are all doing it at once, they push asset prices lower, meaning more bankruptcies and rising unemployment, which is already likely in a recessionary downturn. The only way around this (Conservative Party, take note) is to pursue monetary-policy goals using fiscal policy. With tax receipts falling, that means higher borrowing. But rather than cutting VAT (which is deflationary), the government should provide temporary aid to small business and home-buying borrowers during the period (usually four to five years) that the banks will be pulling back from providing loans. A government-sponsored housing-loan corporation, for example, would help ensure that when house prices do reach their potential clearing price (ie, where frustrated first-time-buyers feel they would be tempted back into the market), such buyers can actually get access to a mortgage. That's important, given that net mortgage lending looks set to be negative next year.
While the jump in government debt looks very inflationary, the strong deflationary effect from shrinking bank lending means we'll be lucky if the net result is mere disinflation. But, the FT asks, what if foreign buyers go on strike? Governments don't default on their debt by not paying, but rather by paying in a devalued currency. Increased supply would normally push gilt yields higher.
But that's not what has happened in past banking crises. Banks in crisis stop lending to people like us, who may not be able to pay them back, and develop an insatiable appetite for risk-free assets, by which I mean government bonds. Quite apart from investor portfolio demand for gilts in a deflationary recession, the new big buyers will be the banks.
That's why, since the Chancellor last month announced the need for £110bn to finance bank bailouts, then raised that to almost £150bn in his Pre-Budget Report, the yield on the ten-year gilt has not risen but instead has raced to a new 40-year low (gilt yields fall when prices rise). That's happened despite the fact that the previous record gilt issuance in any one year was £62.5bn. The four to five-year bull market in gilts has only just begun.
James Ferguson is chief strategist at Pali International. He also writes the Model Investor newsletter. See here or call 020-7633 3634 for more.
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James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.
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