Northern Rock example, The

Credit Management, Apr 2008 by Johnson, Marcus

In the first of a two part series, Marcus Johnson gives answers to some of the burning questions around the Northern Rock affair: whose fault was it? Will it happen again? What should the government do? He commends the nationalisation of Northern Rock and suggests returning bank supervision to the Bank of England.

Introduction

When the BBC commissioned Cranford they probably did not confer with Gordon Brown or governor of the Bank of England and yet the scenes outside the Town and County Bank shown on the country's TV screens were to be repeated at huge cost to both those gentlemen's career prospects within weeks. This was partly as a result of the BBC illustrating, with wonderful clarity and timeliness, just how vulnerable we all are when a central pillar of our economic life, our money, collapses.

So whose fault was it? Will it happen again? What should we do? For those whose attention span is now at an end the answer to these questions are, in brief;

1) It is Gordon Brown's fault, but because of what he did to the Bank of England years ago, not because of current actions.

2) It will happen again. The nature of banking is that banks will always find new ways of losing money.

3) We should hand responsibility to the Bank of England. Banks are part of the monetary system and control of banks must be unified with control of all the other tools of monetary policy. In the case of the UK, historically this has (until very recently) been done by the Bank of England.

Before illustrating these answers more fully I need to explore in more detail what is special about money and what role banks and governments have. Money is special because we all say we want it but we do not really mean that unless we are numismatologists or scripophilists. We cannot eat it, it does not keep us warm or dry and not many people use it for any purpose relating to its physical properties. (As I write this in Cambridge I assume that the alleged abuse in city dealing rooms which results in 10% of £50 Banknotes being contaminated with cocaine is fictional). No, money is not what you want - it is the power it brings to obtain goods and services we are talking about in shorthand when we say we want money. At school we were taught that money is a store of value, a unit of account and the medium of exchange and it is the first of these which I shall now talk about.

What is money?

Money is the most important invention for economic welfare after language itself. Language allows ideas to be exchanged and bargains to be made over distances and time and therefore permits much more complex economic models to operate than is possible in a face-to-face, you-scratch-my-back-and-l-scratch-yours or a 'I will give you a chicken or some eggs if you give me some milk or some beef. But money is almost as important as language because it allows time and distance of trade to increase with no bounds as long as the parties involved believe that it exists. Money in effect interposes a third party guarantor that says if you sell your chickens today some milk will appear in exchange in a week or a months time. As long as you can believe in that third party's integrity you will happily work for pieces of paper or for electronic entries on a computer even though what you actually want in return for working is use of goods and services in exchange for your time.

So money is purely a figment of your imagination and as long as a lot of other people share your illusions everything works fine. If the illusion fails then everyone who was owed goods and services loses out and everyone who was due to deliver them is let off. Look at Zimbabwe today if you want to see what happens when the illusion has been shattered. Essentially, if you cannot see the man with the milk you will not hand over your chicken so trade grinds to a halt, cars rust in the driveway, unimaginable deprivation becomes widespread and the people starve. This may seem like a long way from Northern Rock but it is not, it is exactly the same problem - the illusion that money is a store of value only lasts as long as the rest of the world accepts it as such. The roles of those who act as guarantors that others will deliver goods and services is absolutely vital in maintaining the illusion. This is what banks and governments do.

The role of banks and governments

Neither banks nor governments are necessary to the existence of money and indeed money is so useful and so profitable to all who believe in it that for most of history it has existed in some form in almost every society for which records exist. Whether in the form of conch shells, lead, salt, copper, silver or gold, societies would evolve a standard unit of exchange so that trade could take place. As soon as the government could standardise the medium of exchange over a wider distance and a larger population the gains from trade in terms of prosperity become immense. This is because the risks in trading are always reduced if there is a credible guarantor of standards and most spectacularly this is the case with money. The development of governments is often seen as a supply push - the king expanding his realm - but in reality it has often been a demand pull - neighbouring regions wanting the prosperity resulting from an efficient trade mechanism.