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What can the UK's government do to get credit flowing?

Guardian Economics 14th January 2009

For all its shiny buildings and big bonuses and exotic jargon, banking is not so different from indoor plumbing. Few people get worked up about the humble U-bend, but when the water stops running it suddenly becomes all-important. So it is with finance: the vital function of high-street banks is that they keep money flowing to where it is most needed. The opposite has happened during the credit crunch. Sound companies that need cash to keep ticking over have suddenly found it harder to raise. Banks which were all too willing to spray huge mortgages around in the bubble years are scarce now bricks and mortar are at less-stupid prices.

Officials have tried some big measures to fix the financial plumbing over the last few months. There was October's £50bn cash injection into banks and the clampdown on short-selling of financial shares – both attempts to mend the pipes. In a bid to get credit flowing, the government guaranteed lending between banks, and the Bank of England slashed interest rates. Yet none of these have done the trick, which is why yesterday Gordon Brown tried another tactic: underwriting some bank loans to small and medium-sized businesses.

As remedies go, this one is shrewd but small. Ministers are stumping up nearly £12bn, a lot of taxpayer cash but small besides the drop in bank lending. The bulk of it – £10bn – will guarantee loans to firms in need of working capital. As lending goes, this is the safe, shallow end of the pool: taxpayers will get most of their money back, especially since ministers are underwriting only half the risk. The Tories have already laid into this scheme as being too small, and they are probably right. More such packages are likely over the next few weeks – help for car firms, and perhaps some form of trade credit insurance for exporters – but none will loom large against the giant backdrop of a global credit drought. Business minister Baroness Shriti Vadera said yesterday that she could see "green shoots" of economic recovery. As the months go by and the jobless total marches towards the 3 million mark, that comment will look ever more foolish.

Being small and technical, yesterday's package is unlikely to garner much praise outside the City pages. Yet it deserves some commendation for directing cash to where it is most deserved. Unveiling the Tory scheme, George Osborne put few comparable parameters on lending – so that he could end up handing over taxpayer money to banks that might lend to businesses that either do not need the money or are unlikely to use it well. On this crucial principle, the headline-grabbing Conservative plan falls down.

If Labour is successfully to ease the banking crisis, it needs to show more grasp of principles. Instead, it has sometimes got them rather muddied. Mr Brown has been urging banks to lend at 2007 levels, which is neither realistic nor sensible. At the same time, he and his officials have been declaring the need for institutional stability. But these messages point in two opposing directions: either to more lending or reining loans in to restore financial stability. As the credit crunch turns into a nasty recession, ministers would be economically justified and politically wise if they placed more emphasis on the need for banks to lend. The government owns large stakes in the big banks, yet insists it will not interfere too much in their business. In other words, it wants all the responsibilities but none of the rights.

Mr Brown must make clear that the whole point of October's bold rescue was to ensure the banks would lend. Not at 2007 levels, but at more modest rates, with particular targets for particular industries in need of funds. The Financial Services Authority should ease its rules on the cash reserves to be kept by banks. Mr Brown's team should make it clear that if none of this works, they will consider outright nationalisation. This will be a messy, costly, ­business; but fixing the plumbing often is.

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