Today, in a keynote speech at a breakfast for senior city figures hosted by The City of London, David Cameron said:
“In 2008 Britain faces possibly the most uncertain economic outlook for a generation. Families are deeply worried about their mortgages. Businesses are worried about their credit. And the uncertain economic and financial outlook is reflected in differences of opinion about where to go from here.
“Some say the risk is inflation. Others say it’s recession. So some think there should be more intervention by the Government in the financial markets. Some say there should be less.
“At this time of great economic uncertainty and unease, people are looking to their government for one simple thing: reassurance. Reassurance that the Government knows what it’s doing. That it has a plan to steer our economy through the present turbulence into more stable and prosperous conditions.
“But the current Government is simply unable to provide that reassurance. On the financial crisis, we have seen dithering and delay - instead of decisive action. Worse than that, the financial crisis has itself revealed the serious failures of economic strategy since 1997. As the tide of debt-fuelled economic growth recedes, we are now seeing the rocks exposed: the rocks of an economy that is in no fit state for the twenty-first century.
“So today I want to set out my understanding of the problems Britain faces – and chart a way through them that I think we need to take. While the drying up of liquidity in money markets, the reduction in the availability of mortgages, and the collapse of banks are the most immediate symptoms of the crunch, the causes run much deeper.
“Today I want to look at the lessons we need to learn from the current crisis. First, we need to learn the lessons of the bursting of the debt bubble and reform our macroeconomic framework, especially the system of banking and credit. And second, we need to learn the lessons of globalisation, and improve our competitiveness by putting our economy on the road to long-term sustainable growth.
The credit crisis
“Before we get into the specifics of the credit crunch, let me explain my overall approach. When I studied economics in the 1980s, two great ideas were in contention. And over the course of that decade, one idea won and the other lost. I always knew which side of that debate I was on.
“At the end of the 1970s the consensus was that you improve growth by using macroeconomic policy, and you control prices using microeconomic policy. By 1990, the consensus was exactly the reverse. Macroeconomic policy – taxes, spending and interest rates – should be used to stabilise the economy and prevent inflation taking off, and microeconomic policy – supply side reforms – should be used to improve growth.
“In terms of macroeconomic policy, a series of monetary policies were introduced, until with the introduction of inflation targeting in 1992, we adopted the best system for managing the demand-side in modern times.
“Interestingly, this was a debate from which the Labour party was almost entirely absent. But, to give them their due, in 1997, Bank independence, introduced by Labour, was an idea whose time had come. I welcome the independence of the Bank of England and in office we would strengthen it.
“However, we now face a new challenge. Recent threats to stability have come not just from the demand cycle but from the credit cycle. Over the past decade we have seen rapid rises in the liabilities of households, companies, and banks. As we have warned for years, debt levels have risen unsustainably. And at the same time, all this borrowed money has led to increased asset prices.
“But the problem is not just that the latest boom was built on an unsustainable growth in terms of money, debt, and asset prices – or in modern terms, liquidity, leverage and credit but that many of the debts – the CDOs, SIVs, and SPVs – were not fully understood by the institutions that had lent them and that many of the assets - including the now infamous sub-prime assets – turned out not to be worth what they thought they were worth.
“In the past, this rapid rise in money would have led quickly to retail price inflation. But two things have stopped this happening. First, inflation targeting has subdued wage and price pressures by anchoring expectations. And second, there has been a plentiful supply of cheap retail goods from China. The result is that rising demand has not yet stoked a corresponding rise in consumer prices. This has encouraged certain hubristic politicians to proclaim ‘the end of boom and bust’.Yet what we are discovering now is that the link between money and inflation has not in fact been broken.
“For a start, some consumer prices are rising – in some cases dramatically. As the report we issued on Monday showed, we are witnessing a steep rise in the cost of living. But inflation has been worst over the last decade in the asset markets. While this has been good news for home-owners and investors who have taken advantage of rising asset prices … the underlying facts are bad for our economy.
“To the extent that this is unsustainable, this rise in asset prices relative to retail prices can only unwind in one of two ways. Either asset prices can fall. Or retail prices must rise. Both are disruptive to the economy, and to millions of families around the country. Ken Rogoff, the former IMF Chief Economist, summed it up with a quote from Robert Frost: “Some say the world will end in fire, some say in ice.”
“So what now? What would be quite wrong is simply to reflate the bubble, and imagine our problems would be solved. Instead, we need to recognise that the cycle of easy money and easy credit is a function of the financial markets and it’s there we need reform.
“All this has created a set of circumstances we have never before faced in our lifetime … or indeed in recent history. There are a series of diagnoses and prescriptions which have the attraction of simplicity – but the dangers too. For instance, some argue that the risk and the reward incurred by bankers need to be conjoined – and that means letting all banks which get into trouble go to the wall. The argument runs that you’ll only get responsibility from investors and traders if you end for certain the moral hazard of government protection.
“The opposite argument says this. In today’s interconnected world, you simply cannot let any bank go under: so we need to control every aspect of the financial system so that banks can never get into this sort of trouble. This will lead to less dynamism in the economy but more safety.
“Neither argument is right.
“We need to avoid a rush to judgement and an instant rewriting of all the regulatory rules. Indeed, the worst response to the current crisis would be a knee-jerk response and proscriptive over-regulation. The UK has a long history of benefiting from over-regulation elsewhere from the emergence of the Eurodollar market in the 1960s thanks to US tax policy to the effects of the Sarbanes-Oxley legislation in recent years
“And let us not, in responding to the current crisis, sow the seeds of the next one. For as the need to rescue Bear Sterns showed, the complexity of modern finance is one of the problems in dealing with the current crisis. Britain’s economy is powered by financial services and in many ways that’s a good thing.
“The City of London is one of the most important industries in our country, and over the twenty years since Big Bang it has generated wealth for us all, and allocated finance more efficiently throughout our economy and indeed throughout the world. But that doesn’t mean we need a credit free-for-all.
“The case for banking regulation is based on a simple fact. When banks succeed, they make huge profits. When they fail, other people – their creditors and in particular, in the case of Northern Rock, taxpayers – also pick up the pieces. This asymmetry between private reward and public risk is not, as some on the Left would say, an argument against banking or the whole system of credit. It’s an argument for banking regulation – and closer regulation than would be justified in other areas of the economy.
“So let us consider what practical reforms we can put in place. We need to reform prudential banking regulation so that banks themselves, and regulators if necessary, act sooner. As the FSA has acknowledged, senior, experienced regulators should have known much earlier that Northern Rock was sailing too close to the wind.
“And we need to give back to the authorities the power to rescue a bank that is in trouble. When a US bank got into trouble, the authorities stepped in and sold it over the weekend. Here after five months of dithering the Government was forced to put through the nationalisation they had tried for so long to avoid.
“Let me be clear, we are not calling for the regulation of banks to be put back into the Bank of England. But the Bank of England must be put in charge of rescuing a bank.
“Recent events have strengthened the argument for the Bank exercising this power for three reasons. The regulator should not also be asked to decide when to trigger a rescue, as a bank rescue often follows some degree of regulatory failure. The Bank of England needs to be more closely involved in the health of the banking system as a whole, and its systemic role would be strengthened by the duty to monitor banks in need of rescue.
“And we have learnt over the past nine months just how inseparable monetary policy and banking are how you deal with a bank crisis directly affects the impact of monetary policy on the rest of the economy..
“As well as the reforms we have outlined for the UK financial system, we need reforms at a global level too. So let me suggest one important reform that needs to take place in light of the recent crisis in world banking.
“The Basel capital accords determine how much capital a bank must set aside for a given amount of lending. This makes good sense, and, for obvious reasons, it is right to set the rules at a global level. But economists have identified some key problems with the current Basel accord.
“First, the rules on liquidity, which has been at the core of the current crisis, are too weak. Banks can operate with enough funding only to survive for a couple of weeks, but still be within the rules. Second, we need to examine which asset classes and which institutions are covered by existing rules. For example, the zero-weighting of some triple A assets has led to distortions in asset allocation. Put simply, some of the debts were kept off balance sheet so they didn’t count as lending under the rules.
“Third, judgements about credit risk were delegated to rating agencies who themselves had incentives to expand the amount of lending that was allowed under the rules. Put simply, because they are paid fees for rating debts, credit rating agencies had an interest in there being as much debt as possible. Finally, market risk was measured by backward looking models which tend to exacerbate the credit cycle, not dampen it. When credit is easy, the models allow more lending. When credit tightens, the models reduce the amount of permitted lending.
“In short, liquidity risk was all but ignored, credit risk was delegated, and market risk was backward looking. And we now know that not only did the regulators not know, but too often the banks themselves didn’t know, the full extent of the risks they were subjected to. But let me say again, any reforms at an international level will need care to ensure that in tackling the past problems they do not create the problems of the future. At the same time, we must all recognise that crises are inevitable, so a prudent Government, as we will be, that is committed to economic stability, as we will be, must improve our response to these crises when they appear.
Our economy today
“If the credit crunch is in the foreground of the current economic debate, the background is no less worrying. Because as the tide of debt-fuelled growth recedes, we are now seeing the rocks exposed: the rocks of an economy that is in no fit state for the twenty-first century.
“Only now is it becoming clear quite how badly prepared we are for more uncertain economic times. In fact, in many ways Britain is the least prepared of all the major economies to cope with the current financial turbulence. This failure to prepare is summed up by three important facts the terrible state of the public finances, the narrow base of our historical economic growth, and our declining competitiveness as a location for international investment.
Consider first the public finances. Our competitors used the fat years to prepare for the lean years. As everybody now knows, governments across the world used the decade of benign global growth to put money aside for a rainy day. According to the Institute for Fiscal Studies, 19 out of 21 comparable OECD countries did more than Britain to improve their fiscal position over the last decade. Ireland and Australia, for example, both now have a “future fund” of assets, providing security against future liabilities and unknown shocks coming down the line. Instead, Britain has the worst budget deficit in the developed world. The result, as was painfully clear from the Budget, is that we have no room for manoeuvre when we need it no other major economy is responding to economic difficulties by putting up taxes in a downturn.
“The second reason why we are badly prepared is the narrow base of our economic growth. Over the past decade, we have relied heavily on four areas: finance, housing, public spending and immigration. Financial services have grown four times as fast as the economy as a whole – meanwhile, manufacturing has hardly grown at all. Housing has grown twice as fast. The size of government has increased a third more than the size of the economy. And rapid immigration has flattered the growth statistics and disguised slower growth in GDP per capita. The contribution of these sectors to our economic growth over the next few years will inevitably be lower than we have become used to.
“The bursting of the debt bubble will almost certainly require a period of retrenchment and consolidation in financial services. Housing is slowing down because it was driven by rising house prices – itself part of the financial bubble. And, because he finally ran out of money, Gordon Brown’s vast and unsustainable increases in public sector expenditure have now stopped.
“The final source of growth - uncontrolled immigration - is never a sustainable basis for economic growth. For 10 years these factors have concealed the fundamental weaknesses in our economy – weaknesses created by the economic incompetence of this Government. The core weakness is the third reason why we are badly prepared – our falling competitiveness. Our competitors didn’t just prepare their public finances. They spent the good years improving their competitiveness too. Here in Britain, however, higher taxes, more burdensome regulations, higher public spending frittered away without the improvements in services that increased spending deserved all this has led to Britain’s competitiveness falling during the global boom.
“The result is that average productivity growth has fallen. Gordon Brown has called productivity growth the “fundamental yardstick of economic performance”. He was right – productivity growth is the driver of rising living standards, and after ten years of Labour we are seeing real earnings fall.
Liberalism is not enough
“As a free-marketeer by conviction, it will not surprise you to hear me say that a significant part of Labour’s economic failure has been the excessive bureaucratic interventionism of the past decade too much tax, too much regulation, too little understanding of what our businesses need to compete in the modern world. But in another sense, Labour’s economic failure has been one of inaction. In the past, helping business to compete meant getting government out of the way.
“But the irony is this. The modern, globalised economy, created to a large extent by laissez-faire economics, demands more than laissez-faire economics for success in the future. Yes, government needs to do less taxing and regulating – we learnt that from the success of the 1980s.
“I learnt that lesson personally working for seven years in an industry – television, film and media – that was desperate to compete on a global scale but was caught up in regulation. I saw how government can kill economic dynamism with excessive regulation and taxation. But even a free-marketeer understands that economic liberalism alone is not enough. While we must be aware of the limitations of Government, we should never be limited in our aspirations for Government. It is not enough for Government to get out of the way. It must get involved.
“I'm an MP for one of the fastest growing towns in the country: Witney. There's an incredible hub of science-based businesses in pharmaceuticals and technology that have the potential for further growth. Yet Witney doesn't have a railway station and is connected to the nearest city, Oxford, by just a single-carriage road. Local businesses there don't just need economic stability. They don't just need lower tax and fewer regulations. They need the infrastructure, in the broadest sense of the word, to succeed. They need good transport links so they get their goods up and down the country and beyond. They need contacts with universities so they can continue to innovate and create. And they need good local schools which equip the next generation with the right skills.
“Transport. Research and innovation. Education and skills. These are things which our economy needs to prosper. These don't just happen by magic. They need government involvement. But it has to be the right kind of involvement. What’s more, in an age where companies can move anywhere in the world, we need to do more to help businesses set up here in Britain and stay here. This means more than simply providing the right fiscal and regulatory framework, vital though that is.
“So we need a new economic strategy to help our companies create jobs, wealth and opportunity; to attract the best and most productive firms to Britain and keep them here. Not the old bureaucratic interventionism, but a new economic dynamism. Not old-fashioned subsidies for hand picked favourites, but modern support for enterprise and wealth creation. Rather than the do-nothing dithering and the economic incompetence of Labour, we need a new economic dynamism to make Britain the best place in the world to do business. That is the kind of plan we need to help Britain ride out the global downturn and build the foundations for future economic success.
“Our current Government has got this completely the wrong way round. When they should be getting out of the way they regulate and tax too much and when they should be providing vital support services they manage to combine complexity with inaction.
“When he was Shadow Chancellor, Gordon Brown was worried that his lack of economic understanding would be found out.So he latched onto what was then the new theory sweeping economics – the now famous “post neo-classical endogenous growth theory”. The insight of this theory is now the foundation of the modern economics of growth – that what governments do does matter, because it sets the framework within which businesses and individuals create wealth. This means that microeconomic incentives and structures can raise the sustainable growth rate of the economy … and that government must play its part by encouraging research and innovation, by ensuring the workforce has the right skills, and by providing infrastructure in the broadest sense.
“The tragedy is that for all his speeches on the subject, Gordon Brown failed to put this theory into practice. He blocked progress on education reform. He blocked investment in transport infrastructure. He meddled in the tax system to create special incentives for this or that, but only succeeded in creating more complexity.
“So this is my agenda for microeconomic policy. Yes, continue to liberalise the supply side. That means sharing the proceeds of growth so that the government grows more slowly than the economy as a whole. It means simplifying taxation – especially corporate taxation – and it means regulatory reform. But that’s not enough.
“The supply side of the economy needs more than liberalism. It needs dynamism too. Those who argue that we should be completely indifferent to the structure of the economy are wrong – not least because diversification makes our economy more resilient to shocks. One of the reasons our economy has been so unbalanced over the past decade is that housing, financial services and many other service industries have thrived despite the efforts of Government, not because of them. It’s manufacturing and high-tech service industries that are most reliant on government getting it right when it comes to science, infrastructure and skills – and when government fails it’s they who suffer most.
“Manufacturing has flat-lined over the last decade – one million manufacturing jobs have been lost. While our competitors are gaining market share in global export markets, we are losing it. If we want an economy which is sustainable –we need dynamic supply side reform.
“So that is why Conservatives have developed far-reaching plans to improve the nation’s human resources. Plans for a revolution in the provision of education, focusing help on the poorest areas and opening new schools where parents want them. Plans for real apprenticeships, with training programmes led by the demand for skills. Plans for a revolution in welfare, getting the long-term unemployed off benefits and into work.
“And today I want to set out a new area for economic dynamism. For too long the Government has been afraid of helping businesses. I heard a story the other day. A global IT firm were thinking of where to locate a new European office – Britain or Ireland. They contacted the relevant authorities. The British sent them a brochure in the post with a picture of the Tower of London on the front. The Irish sent a delegation, with drawings on where the new office might go and a presentation explaining local conditions. The firm’s new office is of course now in Ireland. That’s the sort of world class service that British business needs the British government to provide.
“Instead we have a department for business that is not taken seriously and billions of pounds worth of business support services that are universally derided for their complexity and lack of impact. That’s why Doug Richards is leading a review of government support for SMEs, and I look forward to its conclusions.
“I believe there is scope both to make savings in terms of the complex web of support systems and organisations that have been established … and to provide a better service to Britain’s small and growing businesses. But we also need to think about the service that Government provides to all businesses, particularly those for whom locating in Britain is a choice not a necessity. Under the leadership of Alan Duncan, our shadow business team are developing proposals for improving UK Trade and Investment and the whole range of publicly funded support services.
“This, then, is the economic picture of Britain financial turmoil in the foreground and, looming in the background, an inexcusable failure to prepare for difficult economic times.
The Conservative Party has long term plans to tackle both of these. Sensible and proportionate reforms to banking regulation. A new system to deal with future bank failures if and when they occur. Above all a modern Conservative government will provide the combination of guaranteed fiscal responsibility and dynamic supply side reform that will lay the foundations for sustainable growth long into the future."