I only allow for a partial offset relative to what the Modigliani Miller theorem implies – in fact I assume the offset is only 30% as great, which means that the weighted average cost of cost of capital rises by 70% of the baseline 10. Making this adjustment reduces the estimated present value of the cost of permanently higher bank capital by about 1% of annual GDP – from just over 4% to 3%. The major part of this remaining cost reflects that fact that we assume that all interest paid by banks on debt they raise is tax deductible at the corporation tax rate (of 28%) while equity capital has to earn the required rate of return out of post tax profits. But in thinking about the wider economic impact of a switch to less tax sheltered funding for banks we need to take account of the extra revenue generated for the government. The government could use the extra tax revenue it gets from banks to shelter the users of bank loans from any knock on impact on their cost of raising finance. This seems a natural assumption to make. And it would mean that we should reduce the estimated negative impact on economic activity.
Reacting to today’s inflation rate (which reflects where the level of prices is now relative to 12 months ago), rather than where inflation will be looking ahead, is not the right thing to do. The inflation rate can move a lot in a short period. Inflation was barely 1% less than a year ago. But this is a difficult situation to have to deal with. I dislike clichés so will resist the temptation to talk about the ship having being blown near to the rocks and now having to steer a difficult course in treacherous waters with rather out of date maps that have not been updated since noone expected we would be in such a place. But it is a temptation since it is not a bad analogy. How we came to be in this difficult situation is something on which many books have already been written. At the heart of the problems has been a banking system which proved catastrophically fragile. That fragility reflected the fact that many banks had come to have very high leverage – a lot of debt relative to capital – which made them vulnerable to concerns about losses on their assets. This poses a big and obvious question: how do we reduce the fragility of the banking system in a way that does not come at too high price – a price may come in the form of a lower level of overall economic activity?