The Current Weakness of the UK's Banks Will Contribute to Calls for More Quantitative Easing on Thursday

The UK economy has been showing signs of a slowdown recently and as this is a week in which the Monetary Policy Committee meets there is likely to be a debate over whether more easing is needed. One member of the MPC Adam Posen has argued for an extra £50 billion of Quantitative Easing for some time and only last week Martin Weale who had only recently voted for an interest rate rise gave a speech implying that he now might consider further easing. So inspite of the fact that the Shadow Monetary Policy Committee voted for an interest rate rise this month the actual one is much more likely to be considering further easing. Indeed the Shadow MPC seems somewhat confused at this time as not only did it vote for a 0.5% increase in official UK interest rates but it also said that it was considering more Quantitative Easing in a case of trying to have your cake and eat it to my mind! We also saw Goldman Sachs start to use its influence via the media to persuade the UK that it needs more QE. This made me think immediately that QE was much more likely to benefit them than the UK and that they had already made a case for more QE in the US. Also we should not forget that the latest MPC member Ben Broadbent came to it straight from Goldman Sachs in yet another example in my opinion of the Vampire Squid increasing its grip on us.The supposed reason for it were some reductions in Goldman Sachs' economic growth forecast for the UK but even a cursory glance would tell you that the reductions were not statistically significant and one might also muse on Goldmans poor forecasting record or perhaps I should say poor public forecasting record. Current Evidence on the UK economy The latest economic growth figures for the UK economy have disappointed as a 0.5% decline in the last quarter of 2010 was followed by growth of 0.5% and 0.2% in the next two quarters. It is possible that the figures for the second quarter were depressed by the public holidays around the Royal Wedding and some improvement may be felt in the third quarter we are in now. Although we should not forget that we were originally told that the Royal Wedding would boost the UK economy! Unfortunately there are also headwinds from around the world and I have discussed the way that both the United States and the Euro zone have weakened in previous articles. Also in a subject I will discuss in more detail the pressures affecting banks around the world are also affecting UK banks with the US “foreclosuregate” scandal being something that is currently having an impact with both Barclays and Royal Bank of Scotland's share prices having fallen by 7% today as I type this. Purchasing Mangers Indices These measures are by no means perfect but they have the advantage of being relatively timely and also that other statistics have become less reliable. Accordingly they are followed more than they used to be. If we look at the latest series of numbers for August we find the following. Manufacturing was 49 in August which was the lowest number for more than two years ( the base level is 50 here where numbers above show expansion and numbers below contraction). This is particularly disappointing if we recall that at the turn of the year the outlook for manufacturing looked strong meaning that we have lost momentum here. Construction was a little better at 52.6 although it too was slowing from previous numbers.However the main number in this series is the services sector as this represents some two thirds of the UK economy. The good news is that the headline number remained above 50 at 51.1 so there is still some expansion. But the bad news is that the index had fallen some 4.3 since the previous month which rather chillingly is even quicker than the rate of fall seen around the time of the collapse of Lehman Brothers in late 2008. It is possible that the riots which took place in August affected activity but they seem to be at best a partial explanation. So if we take all three measures together we see signs of a disappointing August for the UK economy. The wider economic outlook If we look at our main trading partners we see signs of a slow down too which does not help our outlook for exports. The parts of the world which are growing strongly are unfortunately mostly ones with whom we trade relatively less. Whilst Europe is always going to be important to the UK I have long thought that many of our politicians obsession with it is influenced by the fact that it is an area highly correlated with jobs for them and that they often fail to dissociate their personal good from the national one. The problems of the UK banking sector are problems for us all This has been a theme of mine for some time. If we look at the UK banking sector in isolation I argued back on the 14th of December last year that the accelerated withdrawal of the Special Liquidity Scheme by the Bank of England would lead to a tightening of monetary conditions and less bank lending. I was thinking mostly of the impact on mortgage lending then but the impact has been to weaken our banks and their lending just as other factors have weakened them too. You cannot with draw some £185 billion without expecting some impact. At the same time the weakness in the Euro zone has also made our banks weaker via two main routes. Firstly they have some business in those countries and secondly via the impact of the crisis on other banks. We have seen banks in Ireland be destroyed by the crisis and many Greek ones now resemble a boxer who has taken far too may punches to the head. But banks in France are being hit hard to with the Financial Times reporting today that US money market funds withdrew liquidity from them agin in August. As the banking sector is so interrelated such moves have an influence on many other banks and the effect can be felt a long way away from where it takes place. Whilst these two factors raise plenty of problems one more has come to the fore in the past few days. This is the scandal in the US housing market which I have labelled “foreclosuregate”. I explained the situation here back on the 15th of October last year in detail but let me give you the main facts of what took place. The US foreclosuregate scandal When mortgages were securitised (yes we are back to mortgage backed securities…) a lot of the paperwork was not completed properly by the banks in spite of the fact that these were legal documents. This was then exacerbated by the fact that these mortgages were traded and the title was transferred up to ten times. Due to the credit crunch some of these mortgages were foreclosed upon (repossessed) and it then became clear that there was an utter mess. The banks promised to fix this and to investigate but instead made it worse. In a scenario which if it was in a book in the fiction section would be rejected as too ridiculous they employed people with no legal experience to do this and the affidavits which were supposed to clear this up often turned out to be illegal themselves! One example of this was a Linda Green who signed tens of thousands of these. Now we can see how this has log-jammed the US housing industry with debate over who owns which house and which mortgage. It must be very unfortunate for those who wish to move and cannot and simply dreadful for some of those in the position of being foreclosed on (or not…). But whilst expressing sympathy with them for the rest of us we now are beginning to see how much damage the banks have done to themselves with this. It is no surprise to see some of the big US banks such as Bank of America and JP Morgan affected by this.But UK banks are being directly hit too via their US subsidiaries. Barclays and Royal Bank of Scotland are the main two UK banks affected. The precise way that this is taking place is that the US Federal Housing Finance Agency is suing some 17 banks for their part in this scandal and if we remain looking at the UK banks it is suing Barclays over some US$4.9 billion of securities and RBS over US $30.4 billion. Care is needed as value is not the same as losses and a guide can be gained from Union Bank of Switzerland where estimated losses are 20% of the value but it is significant for the banks involved. Furthermore there is the impact on the wider banking sector which will be weakened (again). And whilst I am a big believer in the principle of innocence being assumed I doubt if anyone actually believes the banks are and the real question is how much will this cost? Comment As I have discussed today there are considerable headwinds for the UK economy which in my opinion are being added too by the weakness in the UK banking sector. A signal of this can be found by going back to when I first wrote about the Special Liquidity Scheme back on the 14th of December and looking at the share price of our bank most linked to investment banking Barclays as it was 272p then compared to 153p as I type this. Adding this to signs of an economic slowdown causes a problem as we need credit to flow as freely as it can right now and our weakened banks are unlikely to be able to provide enough of it. Indeed it looks as if RBS may need further support from the taxpayer. This brings me to one of the themes of this blog that in many respects we have repeated the error Japan made when it entered into its “lost decade” and created our own zombie banks. A zombified banking sector is one more reason why more Quantitative Easing is unlikely to help the UK economy. As I have argued before we need to substantially reform our banking sector before we can make any real progress. However we will have to advance on it in a sober fashion as I fear that a thorough audit will have an initial shock impact as we discover that the situation is worse than we thought. But after then we can begin to improve rather than spending 3 years treading water (and paying bank bonuses..) as we have just done. Shaun Richards is a freelance economist who writes the

blog at Mindful Money.