Jeremy Warner: Government is guilty of double-talk over bank lending

Outlook How to get the banks to start lending again? This, as the Governor of the Bank of England, Mervyn King, has this week made plain, is now the number one challenge for economic policymakers as they grapple with the ever-deepening financial crisis. Nothing the Government has done so far, awesome in size and radical in nature though it might seem, has managed to do the trick. Other than beg, bully and berate the banks into lending a helping hand to struggling businesses and householders, what can, or should, the Government be doing?

For the time being, good old-fashioned bank bashing seems to be the order of the day, for which, by the way, there may be something to be said. Huge amounts of taxpayers' money have been pumped into the banking system over the past year and a half, culminating in the current £37bn recapitalisation programme, yet still it hasn't persuaded the banks to reopen the credit markets and start lending again. Many politicians regard the banks' behaviour as incomprehensible, and accuse them of hoarding money to pay dividends and bonuses.

Unfortunately, it is not quite as simple as that, and policymakers know it. There is plenty of double-talking, both from the Government and the Bank of England. The threat to nationalise the banks unless they start behaving themselves is fatuous. Even if the Government could afford to take the liabilities of a Royal Bank of Scotland or Lloyds TSB on to its books, which it can't, it's not clear it would lead to an immediate resumption in lending.

Only one bank, Northern Rock, has so far been nationalised outright, yet there is no sign of this institution opening the floodgates of lending to households and business. To the contrary, the Rock is engaged in a process of "deleveraging" or balance sheet reduction far more vicious than anything seen in the private sector.

The problem the banks have got is not so much a lack of capital, which the Government's recapitalisation programme has in any case now largely fixed, as a continued absence of funding. Until this is resolved, they remain basically incapable of lending at formerly buoyant levels. Nor actually, if they are honest about it, do the authorities want them to.

According to the Bank of England's last financial stability report, deposits and lending across the British banking system were essentially in balance as recently as eight years ago. Yet by last year, the banks were lending £666bn more than they had in deposits. The difference was accounted for by securitisation and wholesale money markets, both of which are now essentially closed as a source of funding. It is this funding gap, rather than an absence of capital, which is causing the squeeze on ordinary lending. While with one hand ministers and officials chastise the banks for not lending, with the other they tell them to reform their over-geared balance sheets, to exorcise the profligate lending of the past and to get back on to the straight and narrow of lending financed wholly from retail and corporate deposits.

The tripartite authorities seem to want to have it both ways, they want both more and less lending at the same time. The message is not so much mixed as entirely contradictory. If it were simply a question of lending more to the wholly creditworthy, the banks wouldn't have a problem with it.

Even in today's crippled credit markets, top lawyers or civil servants who wish to remortgage their houses would have bankers queuing round the block to take their business. As ever, it is the less creditworthy and socially needy among householders and small businesses that the Government wants bankers to support. Yet it was overly aggressive lending to this cohort of borrowers that helped cause the banking crisis in the first place. Ministers seem to want to replace one set of bad debts with another.

All that said, the two policy objectives – balance-sheet reform and more credit for struggling small business and mortgage borrowers – are not entirely irreconcilable. The great bulk of the excessive leverage that built up in the boom relates to housing and financial securities, not to corporate or small business lending. Yet all lending is suffering during the current phase of adjustment. The good is being punished alongside the bad.

There cannot be any economic recovery until the process of deleverage is halted and reversed. Worse, there is now a real danger of a classic, Japanese-style, debt deflation.

Such a downward spiral would work like this. As the quality of loans deteriorates, it creates bad debts which when written off eat into capital ratios. To repair the damage, banks start to shrink their balance sheets by calling in perfectly good loans. In such circumstances, even solvent companies find it difficult to borrow, so they sell assets, which further depresses the value of those assets, creates more bad debts, and so on.

Japan spent more than a decade trying to break this vicious cycle, and even today hasn't wholly succeeded. Western policymakers are now facing much the same challenge. If both interest rate and fiscal action fails, what else is left to persuade bankers to lend and punters to borrow?

Officials on both sides of the Atlantic are studying two possible tools – quantitative easing and debt monetarisation. The two things are slightly different but amount to much the same thing – expanding the money supply, or turning on the printing presses. If banks are flooded with cash, they can hardly complain about lack of funding and may therefore begin lending again. Policy in the US, which with close to zero interest rates has run out of road for monetary easing, is already in debt monetarisation mode. The Federal Reserve is creating new money like topsy.

The same cannot yet be said of Britain. The Government through the Bank of England is providing plenty of funding to the banking system, but banks are required to lodge assets by way of collateral. No new money is therefore created. In any case, mindful of Britain's inflationary past, the Bank of England would be reluctant to go down the quantitative easing route. It's radical stuff and wouldn't necessarily work

Nor would it be desirable for the Government to bypass the banks and lend directly to small businesses. With no expertise in credit assessment, this approach would be fraught with difficulty and would in any case be wide open to accusations of abuse and pork-barrel politics. Warts and all, banks are still the only available option for determining credit allocation.

If the authorities want banks both to deleverage and to lend more to the bits of the economy deemed to require it, there are two possible avenues. One would be to encourage British banks to rein in their international lending, leaving more money for the domestic economy. Another would be for the Government to buy aggressively into the corporate bond market, which for the time being is bombed out and is therefore not a viable source of finance even for investment grade companies. Such purchases would achieve the triple purpose of being a potentially lucrative long-term investment for the Government, providing top corporates with relatively cheap long-term funding, and freeing up capacity in the banking system for a resumption in small business lending.

Even a few months back, all these ideas would have been thought bonkers, and certainly too interventionist to be remotely worth considering. Yet much has changed. Nothing is off limits in the search for solutions.