Even the safety valve of a floating exchange rate cannot insulate an economy from its trading partners. World trade fell by around 5% in the final quarter of 2008. 54 of the 56 nations for which data are available for the fourth quarter registered falls in industrial output. 7 of those suffered double digit declines. For many years trade has been the route to faster growth. Now trade is leading the world down as the economies most adversely affected by the current downturn are those most dependent on exports, such as Japan and some of the other Asian economies, not those with the worst banking problems. Sharp changes in sentiment, confidence, animal spirits – whatever words you care to use – are capable of wreaking havoc on the world and our own economy. I shall turn later to our immediate response to the crisis. I want first, however, to ask whether central banks have the right instruments and the right policy frameworks to deal with a world in which some of the biggest risks are of the type I have discussed earlier, namely events which occur very infrequently but when they do so have large adverse effects; events such as those through which we are living. In other words, was our framework suitable for a world of stability but inadequate for preventing or responding to large adverse shocks?
In the panic of 1906, the founder of what is now the Bank of America displayed his gold reserves on the street and offered to convert deposits into gold, creating confidence in his bank at a time when many others failed. Forty years ago, the clearing banks in London held around 30% of their assets in short-term liquid instruments. Today that liquid assets ratio is about 1%. For the major UK banks, almost 25% of customer loans are now funded by short-term borrowing in wholesale markets. At the turn of the new century it was close to zero. This was the distinctive feature of the contemporary British model of banking. Distinctive it may have been; sensible it was not. HBoS and RBS paid the price as the availability of this funding dried up, and not one of the building societies that de-mutualised in the 1980s and 1990s in order to expand beyond the constraints of their deposit base has survived as an independent entity. Banks have changed. They have encouraged the expansion of proprietary trading, the funding of long-term assets in short-term wholesale markets, a rapid expansion of balance sheets and a marked rise in leverage. Commercial banks followed the path of investment banks. Balance sheet size and high leverage were seen as the key to obtaining funds at lowest cost. The total assets held by the world’s largest banks roughly doubled in the five years to the end of 2008, and leverage in UK banks rose on average by two-thirds.