Debate on Glass-Steagall sharpens up

The UK, along with the United States, is the epicentre of “sub-prime”. Much of the regulatory failure, and the financial culture which caused it, emanated from the City of London.

That’s why our response to the “credit crunch” matters far more than fate of the world’s fifth largest economy. Britain's reaction to our greatest peace-time economic fiasco is being watched around the world. Yet, so far, our policies have been risible.

UK banks still haven’t “fessed-up” their losses. The failure of our politicians, their cowardice in not insisting bail-out cash was conditional on forensic external audits and a bank purge, was a massive blunder. So, too, the grotesque near three-fold expansion of our monetary base – and the use of “funny money” to buy government bonds.

“Quantitative easing”, of course, is creating a new asset price bubble. The City loves it. Share prices have been pumped-up and necessary bank restructuring averted, for now, by our Zimbabwe-style actions.

Yet QE will end and the restructuring will happen anyway, but now in the context of soaring inflation and debt-service costs that will hobble taxpayers and relegate the UK to the economic slow-lane for years to come.

It didn’t have to be this way. But the UK’s “head-in-the-sand” politics and the “never say boo to a goose” nature of our policy discourse means our credit crunch “cure” will ultimately make a terrible situation even worse.

Having wrecked our public finances, the UK’s political and financial elite must now work out a “regulatory response” to make our banking system safer. Enter Mervyn King. On several previous occasions, the Bank of England governor has warned we urgently need to re-build the “Glass-Steagall” firewall between commercial banks (that take deposits) and investment banks (that drive enterprise by funding risky projects). Both activities are needed, of course, but when the same entity does both it’s lethal.

Why? Because the deposits of ordinary firms and households are necessarily covered by a taxpayer-backed guarantee. But when a “high-risk high-return” investment bank culture pervades a commercial bank, the former dominates – so state-guaranteed deposits are levered-up by bonus-fuelled executives then used to gamble recklessly. If such bets work, the banks win big. If not, the taxpayer foots the bill. As King said last week, this invidious reality, and the “breath-taking” scale of the resulting bank bail-outs, has created “the biggest moral hazard in history”.

The UK’s implicit banking firewall was torn down as part of the City’s “Big Bang” in the late 1980s. The US followed, repealing the “Glass-Steagall” legislation introduced in 1933 in the aftermath of the Wall Street crash.

Since then, the Anglo-Saxon world has lurched from crisis to crisis. As Larry Summers said last week: “Roughly every three years for the last generation, a financial system intended to manage, distribute and control risks has, in fact, been the source of risk – with devastating consequences for workers, consumers and taxpayers”.

This is true. Yet it was Summers, as Bill Clinton’s Treasury Secretary, who removed Glass-Steagall, ensuring the outcome he now so laments. And it is Summers, as Barak Obama’s Chief Economic Advisor, who has become the main obstacle to re-instating this vital safeguard against future financial collapse.

As the bank rescues continue, our public finances bleed ever more red ink. The UK borrowed £77bn during the first six months of the year – more than double last year’s total. At this rate, we’ll issue £220bn of gilts during 2009/10, with such crippling debt-accumulation continuing deep into the next decade.

Yet it’s because our banks became “too big to fail” and were able to take crazy risks with ordinary deposits, that sub-prime has resulting in a fiscal crisis too. And this situation arose precisely because commercial and investment banking activities were combined in so-called “universal banks” once Glass-Steagall was removed.

Wall Street and the City, along with their captive politicians, stand in the way of re-imposing Glass-Steagall. Yet, together with King, brave heavy-weights such as Nigel Lawson and Former US Federal Reserve boss Paul Volcker are now speaking out.

“The arguments in favour are compelling,” said Sir Brian Pitman, when I recently asked him about Glass-Steagall. “The case for it is strong”. A former Lloyds TSB Chairman, Pitman is possibly the most respected British banker of the last 20 years. “In the end, the UK can never do it alone,” he concedes. “The vested interests in the US are simply too great”.

I agree with Pitman's analysis but not his conclusion. By leading the charge towards a new Glass-Steagall, an incoming Tory government could do much to restore London’s name as a centre of regulatory excellence. Where the UK feared to tread, the rest of the world – sick of the financial volatility of the last 20 years – would eventually follow.

The Tories’ current stance is that with regulatory tweaks we can avoid root-and-branch banking reform. To quote Mervyn King, this is nothing but “delusion”.

THE WRITING IS ON THE WALL -CHEAP OIL WON'T RESCUE WEST

I was in Beijing last week, as news emerged that the UK’s recession is now officially the worst on record. The contrast between my native country and the one I was visiting could not have been more stark.

The British economy shrunk 0.4% between July and September – the sixth successive quarterly contraction. That hasn’t happened since such data were first recorded in 1955. UK GDP is now a massive 6pc smaller than it was this time last year. France and Germany are showing signs of growth but Britain remains locked in a deep recession – given our over-reliance on the service sector and financial services in particular.

The ghastly figures saw the pound plunge 1.7pc against an ailing dollar and by even more against the euro. Weaker sterling makes UK imports dearer, stoking further the inflationary fires this column has warned about for months.

China, meanwhile, grew at a staggering 8.9pc in the third quarter. Some question the figures, but no-one can deny the Chinese economy, after last year’s export dip, is now roaring ahead once more.

It used to be the case that when the Western world went into recession, oil prices would automatically fall. As the principal energy consumer, a weaker West meant the global economy needed less crude. The resulting lower energy costs would help us escape recession, easing fuel bills while allowing our central banks to cut interest rates with less fear of inflation.

The world has now changed. The West remains in an economic coma, yet oil just hit $81 a barrel – the highest this year and up 115pc since February. The naysayers will point to speculative pressure but, again, that misses the bigger picture. The reality is that the fast-growing emerging giants now make the economic weather – which means oil no longer falls in a way that assists Western recovery.

Transport accounts for 70pc of global oil use. And China's car market just became the world's largest – with sales reaching 9.7m during the first nine months of 2009, a jaw-dropping 34pc above the same period last year. As Chinese workers get richer, such growth is set to continue. There are still only 30 cars per thousand Chinese people – compared to over 800 in the United States.

The return of sky-high growth in China and the other large emerging markets means lower oil prices won’t be coming to the UK’s rescue any time soon.

Liam Halligan is Chief Economist at Prosperity Capital Management