Is the Old Lady safe on her own?

Debt and Delusion
March 24, 2000

Fiscal pessimism is wise, says Howard Davies, but there are limits.

At the Bank of England's splendid tercentenary celebrations in 1994, many guests were surprised to learn that it was not the world's oldest central bank: that honour falls to the Swedish Riksbank, founded fully 26 years earlier, in 1668. But in spite of her "Janey-come-lately" status the Old Lady did for a long time hold a special position in the ranks of the central banks: the prima inter pares , if you like. Yet the most significant development to affect central banks around the world since 1945 had still, in 1994, passed her by. Nationalised by the Labour government in 1946 (the 50th anniversary of that change was conspicuously not celebrated in 1996) she remained - for monetary policy purposes - subservient to the will of the chancellor of the exchequer. In the Ken and Eddie show there was, ultimately, no doubt about who wrote the script.

In May 1997, almost immediately after the election, Gordon Brown changed all that. He announced that, henceforth, the Old Lady was to be her own woman, free to pursue his inflation target as she saw fit, with only a Monetary Policy Committee of nine to guide her.

This new regime, against which both Margaret Thatcher and John Major (though not, we have since learned, any of their chancellors) had set their faces for so long, is scarcely three years old. Yet it already seems a fixed point in our turning world. While others of the Labour government's new constitutional arrangements remain under intense scrutiny, it is now widely accepted that short-term interest rate changes are technical problems, best left to the pointy-headed economists on the MPC. The voting records of the committee's aviary of hawks and doves are submitted to the most intense scrutiny, but it is hard to find a trace of nostalgia for the old regime. And Michael Portillo, William Hague's new shadow chancellor, took an early opportunity of burying the opposition's formal dissent: we are all in the central bank independence party now.

So it is perhaps salutary to be reminded by Peter Warburton that there are those who question the notion that central banks are, and have always been, the fount of all economic wisdom. His polemical tract Debt and Delusion is in a fine tradition of dissent. Warburton is not awed by the gilded halls of Threadneedle Street. The chandeliers leave him cold, the bank's famous claret cellar leaves his withers quite unwrung. He thinks, in short, that the central bankers of the entire western world have got it wrong, and that Armageddon, closely followed by Götterdammerung and the Four Last Things, is just around the corner.

Warburton's charge sheet is a serious one. He accuses these (as he sees it) unaccountable institutions of negligence, narrow-mindedness and inconsistency. The consequences of these crimes will, he believes, be severe and painful.

The central charge is that "over-emphasis, to the point of obsession, on the inflation objective has blinded governments and their central banks to the risk of widespread default by borrowers. The unpreparedness of the western world can be understood only in terms of ignorance... They do not appreciate how fragile the financial system has become, nor how easily the investment gains of many years could be forfeited. One day the mist will clear and the collective delusion of effortless wealth creation will be shattered. Until that day, we are living on borrowed time".

Warburton, you will see, does not mince words or pull punches. Understatement is not a vice known to him. His prose, indeed, is remarkably colourful for a man who makes his living purveying the dismal science of economics in the Square Mile, as economic adviser to Robert Fleming and Co - perhaps Britain's last domestically owned investment bank of any significance.

But colourful prose is not always a sure sign of clear thought. How strong is Warburton's case? How true is it that central banks have let their governments down, have been too indulgent in their attitude to financial innovation and that, as a result, "the credit and capital markets have grown too rapidly, with too little transparency and accountability"? Should we, as Warburton advises us, be preparing for "an explosion that will rock the western financial system to its foundations"?

I doubt we need be quite as alarmed as Warburton would have us be. He overstates the case. Some passages of Debt and Delusion have an Old Moore's Almanack feel to them. Doomed, is the cry, we are all doomed. But there is a serious thesis too, lurking in the undergrowth, bolstered with charts and graphs, and even an equation or two, albeit decently buried in an appendix.

Warburton makes an important point about debt, and both central banks and financial regulators (not always the same thing these days) should pay serious attention to the conditions that encourage excessive leverage.

There is no doubt that in the summer of 1998 credit conditions had become dangerously loose, which allowed the hedge fund Long Term Capital Management to build positions of a remarkable size, whose unwinding could have generated serious systemic risk had the New York Federal Reserve not facilitated a private-sector rescue. This was a very dangerous episode, whose significance should not be under-stated, even though the fund has recovered some of its value and proved a reasonable investment for its rescuers.

Since then financial regulators around the world have been seeking ways of guarding against a recurrence of those unhappy events, by tightening the terms on which credit is supplied to hedge funds and mandating more disclosure of leveraged positions.

Warburton seems to be half aware of this activity, but condemns it in advance as hopelessly inadequate. He takes little or no notice of the attempts made to reform systems of financial regulation, notably in the UK. We have now brought together the regulation of all financial institutions into one organisation, the Financial Services Authority, so as to facilitate a more comprehensive understanding of the sources of risk in the financial system. Warburton pays no attention to this important change.

He also damages his case by throwing in, so to speak, the kitchen sink. He forecasts that the euro "will play a critical role in exposing the hidden consequences of debt accumulation and financial sophistication" and that a rude shock awaits the Eurozone. Writing in June 1999, he looked forward with ill-concealed relish to a millennium meltdown (and he was not referring to changes in the management structure at the Dome). And he warns that the challenge of the year 2000 for economic managers will be deflation.

It is an unwise regulator who fails to notice clouds on the horizon. Indeed, I lose sleep and require my staff to keep the watches of the night at the sight of a cloud no bigger than a man's hand. But Warburton is the sort of economist who gives pessimism a bad name. Even for a man like me, who has pessimism written into his contract, and who went so far as to marry a woman called Prudence, this is depressing stuff.

Howard Davies is chairman, Financial Services Authority.

Debt and Delusion: Central Bank Follies that Threaten Economic Disaster

Author - Peter Warburton
ISBN - 0 14 0752 8
Publisher - Pengiun
Price - £9.99
Pages - 333

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