Breaking news - HBOS doesn't lose £500 million

It was announced yesterday (see here) that Lloyds Bank, the lucky owner of HBOS (Halifax Bank of Scotland), will have to pay around £500million to HBOS customers who took out a particular type of loan. The long and short of it is that customers were told they would be given notice if HBOS changed its policy from charging a maximum of 2% above base rate to charging 3% above base rate. The policy was changed, as they were probably entitled to do, but notice was not given to all customers who were told they would be given notice. Nonetheless, 3% above base rate was charged. Lloyds has agreed to compensate those who paid the additional 1% but were not given notice.

On the face of it the position is very straightforward. Whether or not customers would have sought a replacement loan on being informed of the change, they would have had the opportunity to do so. As it is they were deprived of that opportunity. Had they been given notice it seems fair to presume that some would have found another lender and ended up paying less than the amount they paid Lloyds, some would have found another lender and ended up paying more than to Lloyds, some would have switched to a different type of loan with Lloyds and some would have just left the original loan in place and paid the extra interest. There is no way of knowing how many would have fallen into each category although it is probably not unrealistic to suggest that most would have left things as they were and just paid the higher interest charge. After all, base rate had fallen substantially and 3% above base was less than many had been paying a year before when the mark-up was 2%.

If this were looked at as a claim for breach of contract the assessment of compensation would be fiendishly difficult. Leaving aside the question whether there was any breach of contract, compensation would have to be calculated by trying to value the loss of opportunity to switch mortgage from Lloyds to another lender or from one Lloyds mortgage product to another. The position would be different for different borrowers, depending on their own financial circumstances and the degree to which they would have been likely to seek out an alternative loan. Few would have been entitled to repayment of the whole of the additional 1% they paid although it is theoretically possible that a very small number would have been able to prove a case for a larger sum (if they were able to satisfy the court they would have switched to a loan charging less than 2% over base).

Reports say up to 300,000 HBOS customers were affected. It would make no sense (except to the bank managers of the lawyers involved) to have 300,000 separate claims. Were this dealt with by way of claims for breach of contract there would be only one claim in which all customers who showed interest would be involved. "Class actions", as these cases are known, are relatively new beasts to the English judicial process, we see them most often when a large number of people suffer personal injuries due to the same cause - perhaps a drug that proves to have bad side effects or a work practice that causes many employees to suffer illness or injury. Although the accuracy of the compensation in each individual case is somewhat rough and ready the process is generally quicker, certainly much cheaper and has the added advantage of everyone knowing their case has been considered in the same way as everyone else's.

The intervention of regulators of businesses such as banking means that legal claims do not always need to be made, the regulator can step in and require redress to be paid for an apparent wrongdoing. This, of course, is what happened in the present case. We will probably never know how much pressure was applied by the regulator and how much the decision to offer compensation was motivated by either a genuine sense of the need to do the right thing or exasperation at Lloyds with the shabby practices of HBOS and it does not really matter. A problem was identified, a solution worked out and litigation avoided.

At the heart of the solution is the implicit assumption that HBOS/Lloyds should not have charged an extra 1% interest without giving notice to their customers. Whether they were entitled to do so in law is not the point, they said they would give notice and they did not; of itself that is bad practice and, some would say, fundamentally unfair. The amount they received from customers by increasing their margin seems to have been around £500million. They simply should not have received that sum in the first place. Had they followed good practice they would have received the money and would not now be liable to repay it, as it is they should not have received it and now must repay it.

In making the repayments Lloyds will not be losing anything they will simply be handing back money they should not have received. It is quite wrong to think of this as a loss. Any loss is purely hypothetical and results from not giving the promised notice - had it been given they would have received £500million, by not giving it they have lost £500million, except they haven't. By not giving notice they lost the chance of receiving up to £500million but they did not lose any money. By not investing one pound on the numbers 6, 16, 26, 32, 33, 34 and 46 for last Saturday's lottery you lost £4million - that is not a loss it is a failure to make a profit that would have ensued from doing something other than what you actually did.

A cup of tea with Mr Darling

Nothing incenses an old Trotskyite like profit. It has been observed that banks are charging higher margins than they did before the financial crisis hit. All the usual special interest groups are rallying round to condemn this wicked greed, shouting from the rooftops that Bank of England base rate is only 0.5%. Today the hapless Chancellor of the Exchequer, the inaptly named Mr Darling, joined in the shouting and said he was going to drag the High Street banks' big cheeses in for a chat. He didn't say he was planning to force them to reduce their margins but that threat was lurking in the background. This impending meeting was first disclosed to the government's official leakee-in-chief and reported by him last Thursday. According to Thursday's leak it is not just the banks that received injections of money from public funds who will attend but also the four largest lenders who had the sense not to tie themselves intimately into the State machine.

It is entirely understandable that both businesses and individuals would like a return to the days of cheap credit but there is no escaping the fact that credit was too cheap and backed by too little security, resulting in significant losses when the borrowers could not repay. You can't have it both ways. Either you lend to decent or good risks and cover your arse with security (in which case the risk of an overall loss from this business is kept low) or you lend willy-nilly and take only partial security (in which case you can hardly be surprised when it all goes pear-shaped). And, of course, the people who are hit hardest are those who over-stretched themselves, the little people for whom Mr Darling has so much compassion that he wants more of them to enter the lion's den.

Having spend a good three or four years moulding a massive pear the banks have woken up to the error of their ways. They don't really have any choice. Not only do existing losses have to be covered but they know that in a deep recession more losses will be incurred as businesses close and individuals lose their jobs. None of this is any excuse for usury but we are not talking usury we are merely talking rates that are a higher than in the mad days.

In his interview with Labour's favourite BBC Poodle, Andrew Marr, this morning Mr Darling said he wants banks to rebuild their balance sheets and that he wants them to lend more. In all of this there is a curious twist. As everyone knows only RBS and Lloyds took the Chancellor's twenty pieces of silver, Barclays, Santander, Nationwide and HSBC kept well away from him. The terms on which RBS and Lloyds were rescued seem to include requirements about lending policies (according to the Pre-Budget Report and today's interview). No doubt these are vague to the point of being useless, nonetheless the Chancellor can say that they made promises about lending and hint that they have broken their word. The other lenders are operating in the real world in which all the usual forces - supply, demand, costs, human error and all the rest - combine to determine the amount they can borrow, the amount they can lend, the margin they apply and the security they require. Absent a cartel operating there is no reason why HSBC or Santander could not undercut the "nationalised" banks and steal a lot of business yet it hasn't happened. Why not?

I am not privy to the workings of the big banks' boffins but the most obvious answer is that they know they have to charge substantially more than they did a year or two ago because they cannot raise cheap wholesale money and they need to cover existing loss-making loans and those anticipated to creep out from under a stone in the next year or so. They do not have a magic money tree of the kind so beloved of socialist politicians, they have a real business to run and just as the prudent individual tries to put a little aside for a rainy day so do well run banks.

One thing said by Mr Darling really made me chuckle. He said "... because of the fact that we've got into this recession, we ... need them to lend money ... that's why we recapitalised them ... and that's why they've got to live up to the promises they made". If we look back to the time of the recapitalisation, we find that he announced the recapitalisation scheme on the 18th of November. There is reference in paragraph three of his statement to the House of Commons to the government imposing terms as to "lending policy and wider public policy issues". Perhaps these wider public policy issues included something about the recession, I know not. Even if they did, just six days later he told us how damaging the recession would be in his Pre-Budget Report, he predicted a contraction in GDP of between 0.75% and 1.25% in 2009. Presumably any obligation to help fight recession is limited to a recession of that magnitude rather than the 3.2% we seem to have experienced so far.

I would love to know why he can't be brave for once and tell people the truth rather than just peddle soundbites to make him look busy. Why can't he say "the days of cheap credit are over, the days of 100% mortgages are over; it's a different game now and you just have to adjust your lifestyles accordingly"? Could it be because he thinks there are more votes in leading the charge to blame the banks? How very cynical I have become, it must be the horse-suppositories.

Saving is at a premium

Sometimes life plumbs such depths of pointlessness that you will do anything to pass the time. I had such a moment yesterday and found myself reading an announcement in a newspaper of the current rates of interest offered by a bank to savers. It was really quite scary, so I had a look at what other banks offer savers.

Obviously the exact details differ from bank to bank but the general pattern seems to be about 0.1%pa for savings accounts where you can pay in and withdraw at will, 1.25% where you have to pay in a certain amount each month and have to give at least a month's notice to make a withdrawal (or forfeit interest in lieu) and 2.5% where your money is inaccessible for a year. There are also numerous special deals paying up to 6% on small amounts for a short time, presumably to draw in customers in the hope they will stay with the bank once the interest rate falls at the end of the promotional period.

A couple of weeks ago I was talking to a family member who was withdrawing some of his savings from his bank because the return was hardly worth having. He is in business in a small way on his own account, owns his home outright and lives modestly, He decided to withdraw as much as he needed to buy the maximum permissible holding of Premium Bonds. For those who don't know, Premium Bonds are a national lottery of an unusual kind. You buy a Bond for between £100 and £30,000 and each pound of your holding is given a unique number and entered into a monthly draw. Prizes range between £25 and £1million and it is claimed that each number has a 36,000-to-1 chance of winning a prize. The really clever bit is that your numbers are entered into the draw every month until you decide you've had enough at which point you can redeem your bonds for the amount you paid for them. A permanent lottery in which you never lose your stake. Except that you do lose a bit of your stake through inflation because £100 "invested" in 2008, or 1998, or 1988 or whenever can only be redeemed for £100 today. I should add that there is another clever bit, all winnings are tax-free.

If you have £20,000 sitting in the bank earning, say, 1.5% you earn a massive £300 on which you will have to pay income tax of at least 20%, making it a cash return of at most £240. Inflation at 3% reduced the value of £20,000 by £600, making a total loss of £360; it's not a very attractive situation. In fact Premium Bonds are statistically even less attractive because the total value of prizes represents, when compared to the total value of all Bonds issued, annual interest of only 1%. That some lucky people receive very substantial prizes is taken into account in this calculation, so the return for most people will be far less than 1%. As far as I can recall I have had £500 in Premium Bonds for over ten years and so far have won one prize of £50.

It might seem silly to risk transferring savings from an account that paid some interest to one which gives just a hope of getting a return, but it is easy to understand why people might do so when they know they are going to lose money anyway. Why not accept the likelihood of a loss through inflation and take a chance of getting far more than any bank could pay you? It has the added fun of any winnings being free of tax and I'm sure that for many the satisfaction of receiving something, however small, that the Treasury cannot claw-back is worth far more than the measly alternative rewards paid at the moment by banks.

Is that a goat? Let's scape it.

One problem with democratic politics is that the politicians need votes to get power. They neither want nor need votes for the sake of getting votes. They want power and gaining votes is a means to that end. There was a time when it was pretty much the only way of gaining power, but now there is a string of well-paid jobs with huge power for those who proved themselves unfit for office in their own country. But I'm not going to dwell on the EU, I want to look at domestic politics because today we saw a pathetic, posturing, amoral lunge for power by the meaningless Liberal Democrats which means, in practical terms, a pathetic, posturing, amoral lunge for votes.

I know that the occasional person pops into my parlour from outside the UK, so I should say something about the Lib Dems, as they are known, because only a very close observer of UK politics from overseas is likely to have any idea they even exist. The Lib Dems are our third largest political party, generally gathering a few percent either side of one fifth of the votes cast at general elections. Although there is no direct connection between the percentage of votes cast for each party and the number of seats in Parliament that each party wins, the Lib Dems usually have roughly proportionate representation in the House of Commons. They have a habit of blowing with the wind, switching their policy platform quite radically from left to right according to the whim of opinion polls, but still they are a minority party with no chance of power unless an election results in no majority in the House of Commons for either of the main parties, in which case they can pledge their voting power in the house to either Labour or the Conservatives, depending on which of the larger parties offers them the tastiest sweeteners. The Lib Dems were formed in the late 1980s by a merger of the Liberal Party and a breakaway faction of the Labour Party which decided Labour had lurched too far to the left (despite the most prominent members of the faction, known as the SDP, being leading figures in the heavily left and heavily disastrous 1974-1979 Labour government).

The Lib Dems have been a bit of a mess for many years. They have had competent leaders and some competent MPs from time to time but something always turns up to spoil things just as they seem to be getting somewhere. Without doubt the most able Liberal leader in recent times was Jeremy Thorpe, until he found himself on trial for conspiracy to murder; his acquittal proving insufficient to resurrect his career. Then they had David Steel for some years followed by Paddy Ashdown, two chaps of great ability but unable to present a third course while the country was arguing between 1970s-style state socialism and dipping a toe in the waters of free enterprise. Charles Kennedy followed Paddy Ashdown. An immensely impressive speaker, poor Charlie was an even more impressive drinker and left behind him a party machinery exhausted by having to cover his arse when he was on a bender. Then came Menzies "Ming" Campbell, a hugely sensible and pleasant man, an Olympic medallist and a perfect choice to be a fair-minded and much liked High Court Judge. Unfortunately he was a party leader instead, in which role his rice pudding-like lack of charisma came to the fore. Now their leader is someone called Nick Clegg, young and rich and with even less presence than Sir Ming Campbell. Their real leader is their Treasury spokesman, Vince Cable, created real leader by the BBC which seems to give him far more coverage than any politician other than poor Gordon Brown. Today Vince had a spot in the party limelight at the Lib Dem's Spring Conference.

One reason, indeed the only reason, Vince deserves the limelight is that he was the only leading politician from any of our three main parties (other than former Chancellors of the Exchequer Ken Clarke and Nigel Lawson and former PM John Major) who warned consistently about the problem of excessive credit. The opinions of Clarke, Lawson and Major were dismissed as the bitter bleatings of yesterday's men, whereas Vince was seen to be a here and now politician. All credit to him (no pun intended) he was right. He was also right in arguing against the government taking major interests in struggling banks because the result would be transferring massive debts from the existing creditors and shareholders, all of whom volunteered for the risk of losing money, onto the shoulders of Mr and Mrs Ordinary-Taxpayer, who did not. Full marks, Vince can spot a problem and explain it clearly. He is not so good at coming up with workable alternatives to the government's panicked lunges from one bail-out to another, but no one's perfect.

The time he becomes awful is when he descends into raw vote-grabbing, then he is cringeworthiness personified. Today provided a classic example. He made a speech to the Spring Conference, a rallying cry to both the party faithful (for whom "both" seems an apt description) and to disaffected Labour supporters. The Lib Dems know there are lots of people who voted Labour at the last election who are not prepared to do so at the next. Some will switch to the Conservatives, just as they switched from Conservative to Labour in previous elections. Others might vote Conservative but might vote Lib Dem, it is these he seeks to woo. The course he chose to take today was to appeal to the basest and most mindless political emotions, envy and revenge. After ensuring he would get the attention of Labour voters by blaming everything on Mrs Thatcher he turned to his target du jour, "fat cats".

His brilliant idea is that everyone paid more than the Prime Minister should have their income exposed to public gaze. Well, actually, not everyone. Only those who are employed by public companies. At the moment the remuneration of directors of public companies must be disclosed in the company's accounts and to the shareholders. This is a long-standing requirement because shareholders have the right to vote down remuneration packages. Many a large company hires the services of specialist advisors who do not actually act as directors because they do not guide the course the company takes, but their advice is relied on heavily. If they cross the line and become more than advisors they can find themselves in the legal waters of the "shadow director", and very deep and pungent waters they can be. Not a few senior business figures deliberately act as advisors only so that they can collect handsome remuneration without having to expose their private financial affairs to the world. Mr Cable's rant explains exactly why they do this.

A cynic might suggest that these people want money for nothing. I would suggest they want a good level of pay for sharing their experience and expertise with those who think it would be beneficial to receive it. We can all hold our own views about whether the remuneration is justified by the level of expertise behind the advice, but, frankly, it is nothing to do with us. And it is nothing to do with Mr Cable or any other politician. Every company has to disclose in its accounts how much it has paid to consultants because it affects the company's financial state, but how much each individual consultant has received is a private matter of no relevance to the financial state of the paying company, any more than it is relevant how much of the fee they pay their auditors goes to each of the individuals who conducted the audit.

Mr Cable was merely jumping on a particularly cretinous bandwagon. We now know that the directors of some banks were lacking in navigational skills. They directed their employers into a quagmire rather than to the land of milk and honey. So be it. It happens. It happens with Billy Blowtorch Plumbing Ltd and Steve Sirloin Butchers Ltd, now it has happened with a number of massive banks. What difference could it possibly have made for the remuneration of directors to be set out in more detail than the law currently requires and for other employees earnings more than £194,000 a year to be named?

How does he think the process would work? "Oh my gawd", says 53 year-old cleaner Gladys Higginbottom of 34 Acacia Avenue, "Royal Bank of Scotland paid some non-directors more than £194,000, they must be speculating on dodgy derivatives and accumulating toxic debt, I will alert my MP immediately and prepare for RBS to be nationalised in three highly inefficient stages." As they would say in the East End of London, do me a favour. Making public the remuneration of employees tells no one anything about how a business is being run. It's just Sunday tabloid prurience.

Perhaps Mr Cable was laying the groundwork for his party to return to a previously favoured policy of punitive additional income tax for those earning more than £100,000 a year. Or perhaps he has let his massive exposure on the BBC get to him. After announcing this absurd proposal he then said "we have to crack down hard on corporate tax avoidance". Not evasion, avoidance. Tax evasion involves not paying what the law requires you to pay, avoidance involves only paying what the law requires you to pay rather than paying more than the law requires you to pay. Did he really mean this? Let's be generous, let's assume he meant to say that he has identified ways in which more tax can be levied by closing so-called loopholes. Fair enough. Put forward your proposal to raise taxes, Vince, and let it be debated. Let's see if your efforts to close what you perceive to be one loophole will do anything other than encourage people to find another. I won't hold my breath.

He then suggested abolishing top-rate tax relief on pension contributions (just as we are beginning to see the true depth of the pensions black hole) and increasing some rates of Capital Gains Tax. This, he claims, will allow tax cuts for the lower paid. Great, that's how much? £5, £10 a year off Gladys Higginbottom's tax bill? Assuming there is any net increase in tax revenues at all, the impact at the bottom of the pile will be negligible.

Throughout Mr Cable's speech there were references to the new bogeyman, the well-paid banker, the current hate figure of populist oratory. It's all a load of complete guff. He can pick on them now to his heart's content. In six months they will be seen for what they are, a very few people who made a lot of money by making bad decisions. We will have moved on from the juvenile blame game to the more serious question of how we pay for the government's cack-handed attempts to deal with current problems. He really should have more sense than to scapegoat a handful of people we had never head of before and will soon forget.

Never mind the quantitative, feel the ...

So, the merry-go-round has been started up in the great funfair of the vanities that is current economic policy. The government is printing £75billion of monopoly money now with up to another £75billion when this lot fails to achieve anything, so we can make that next month then. This is hailed by the BBC as "Bank to pump £75billion into economy". Doesn't that sound nice? We all need more money in these difficult times, how very lovely of the Bank of England to give us all so much to play with. Super.

It reminded me of a divorce case I dealt with twenty-odd years ago in which the the wife was giving evidence about how much money she needed. After describing her need for a house, a car, two televisions, long finger nails and a small poodle was was being cross-examined about how her husband could be expected to find so much money out of his small shop business. Her reply was "he's hasn't just got the shop he's got a company". Indeed he had, the shop operated through a company with £100 of share capital (ironically owned equally by husband and wife). She honestly thought that a company could just make money appear as if by magic regardless of how much went through the till. "Bank to pump £75billion into economy" has the same ring to it. It gives the impression that this massive pot of cash is going to appear out of thin air and be unleashed for the greater benefit.

Of course the company of the divorcing husband might have been able to raise a loan and, in turn, lend that sum to the husband to pay for the wife's poodle, but there would be nothing magical about it. The company would have to repay the loan with interest and the husband would have to repay the company. No magic new money, just borrowed money that will be a net drain on resources unless it can be put to a profitable use. Such borrowed money is new money for the people who borrow it but the crucial point is that it does not increase their net wealth. It puts, say, £100,000 in the credit column but puts £100,000 in the debit column. As interest accrues further debit entries appear and their net wealth diminishes unless there are corresponding increases in the credit column. That is the whole point about credit and wealth. If you borrow money and make it work for you so that you make a greater gain than the amount of interest you have to pay, then you genuinely create new wealth from that money. But if you just spend it on things that get consumed you diminish your wealth by borrowing. Our pitiful government has defined its own profligate spending as "investment" for the last decade, but that doesn't mean it was investment any more than I might go to the supermarket and say I have invested in a pound of cheese.

The contrast between the divorcing couple and the Bank of England is that the latter can just magic new money out of thin air. There is no need to print a single extra £10 note to do this, all they have to do is press some buttons on a computer and "kerching" they have an extra £75 billion appearing on a computer screen and credited to them. So, if Dodgy Mortgages PLC needs £10billion to lend to individuals and businesses the Bank of England can say "We'll give you £10billion for the mortgages loans you made in 2006 and which are now defaulting." A piece of paper is signed, the Bank of England is now the proud owner of the right to receive payments of interest and capital on loans that aren't worth the paper they are printed on and Dodgy Mortgages PLC is free of those bad debts and has a clean £10billion ready to advance to the waiting hordes. In reality all that has happened is that the bad debts are still in existence but an extra £10billion of cash is now floating around.

The problem with doing this is that there has been no increase in real wealth, just an increase in the money supply. The concept of wealth is at the heart of understanding what money is. Money is just a means of measuring wealth. If I own a house, a car, furniture, books, paintings, sculptures and a set of golf clubs, it is those things which represent my wealth. Whether you value them at £100,000 or £2million, my wealth is exactly the same, all that has changed is the nominal value attributed to each pound. And how do we know the current nominal value of a pound? We take the total wealth in the country and divide it by the number of pounds in circulation (OK, there's rather more to it than that, but it's a good rough guide). Increase the number of pounds in circulation without increasing the assets they represent and each pound represents a smaller proportion of real value, in other words you need more pounds to buy each thing. Prices go up. You have inflation.

One problem with inflation is that it makes ordinary everyday things unaffordable for the least well-off. A great many people spend all their income on the basics - housing, water, food, clothing and fuel. Increase the number of pounds they have to pay without also increasing their income and they have to forgo basics. Not nice. A situation to be avoided if possible.

Throw lots more money into circulation and you risk creating huge inflation of the type seen currently in Zimbabwe. So why, one might ask, is the government following that path now? It seems to me there are two reasons.

The first is to create inflation so that current debts (measured in pounds) represent a lower proportion of national wealth. If you owe £100,000, you owe £100,000. If today £100,000 represents the price of a Rolls Royce and tomorrow it represents the price of a Scoda, your debt falls in real value despite being the same number of pounds. This helps you as a borrower and shafts the person to whom you owe money, which in many instances is ultimately an overseas bank or investor. As always, if something looks too good to be true, it is. Domestic inflation hurts the poorest first last and all the time. That is a high risk for any government to take merely to reduce the real value of debts measured in pounds, and it does nothing at all to debts measured in other currencies.

The second is to provide a stimulus to the economy, primarily by making more money available for the banks to lend. At the moment it is asserted that credit has dried up causing housing sales and high street sales to stagnate, and causing businesses to be short of both working overdrafts and loans to fund investment in expansion. If this stimulus works, real wealth could increase thereby negating the inflationary effect of there being most pounds sloshing about. After all, an increase of 5% in the number of pounds in circulation doesn't matter if wealth increases by 5%, the two balance themselves out. So, if you increase money supply by 5% first and this causes a 5% increase in wealth you will reach a balance even if there is a time lag between the two.

To my mind a number of factors point towards inflation being a greater likelihood than a stimulation of economic growth.

First, there is already an inflationary element in the economy because assets have been overvalued for years, especially housing. Our real wealth has been worth far fewer pounds than it purported to be. While the money supply seemed to be balanced with asset values at their over-stated level, as that level becomes more realistic we will have a surfeit of pounds. To throw more pounds into the national pot increases the prospect of inflation in areas other than housing.

Secondly, there are excessive levels of personal debt on credit cards and through second mortgages which will be repaid through cutting back on discretionary spending. Much of the boom economy was built on spending funded by unaffordable credit, that will end. In addition, those burdened with hefty liabilities on credit cards or other loans will repay those debts by not spending at restaurants, clothing shops, electrical good suppliers and all the rest (or they will go into insolvency). The scope for boosting personal spending by boosting credit is severely limited. Shops selling the optional extras of life are likely to be facing a tough time no matter how much extra cash is in circulation.

Thirdly, the stock market falls over the last year have wiped a third or more off the value of many investment funds. The pressure to save more will be strong. Although historically low rates of interest provide a disincentive to save because the value of what you have saved actually falls when you receive 1% interest and general inflation is above 1%, the fact that existing savings have been decimated requires many to do what they can to build up the funds they will need later in life. This, again, acts to restrict the amount people feel able to spend.

Fourthly, borrowing to buy a house or flat will only be done by those who really need to. The housing market is, it seems to me, still grossly inflated and has a long way to fall to get to realistic levels. Even if it only another 5% (highly wishful thinking, in my view) that is still a £10,000 loss on a £200,000 property; no sensible person will take that on unless they have no other option.

Fifthly, the banks have to be more stringent in their lending criteria than they have been for many years otherwise they will just build up another massive portfolio of bad debt. This affects not just lending for house purchase but for everything else as well. Since they must lend less and with greater profit margins, the scope for a consumer-led recovery is reduced further.

Sixthly, lending to businesses is bound to be tighter as consumer spending falls because potential business borrowers will have to explain how they will be exempt from the downturn in spending. At the moment we hear government ministers complaining that businesses can't get the credit they need to keep going, but this assumes they will be able to keep going even if they get the credit they seek. That is quite unrealistic. Many businesses that were a good risk to the banks a few years ago are now a busted flush.

Seventhly, higher taxes will have to bite within the next year or two because the government has borrowed so much money to throw at the problem. As and when the recession bottoms-out, the higher taxes will have to kick-in, thereby lengthening the time before consumer spending can return to anything like the levels of a couple of years ago.

All these points, and there are probably many more, suggest that it is unrealistic to hope we will spend our way out of this hole. Yet again the government has not had the courage to speak the one unassailable truth in all this horrid mess (and, to be fair, the Conservatives also don't have the guts to say it). For years and years we have been living beyond our means and pretending that we have real wealth and substantial spending power when the reality is that we are nothing like as wealthy as we thought.

We have been living a lie and any attempt to resuscitate that lie by trying to stimulate both borrowing and spending is extremely dangerous. Either it will not work at all, in which case the result is massive wasted expenditure; or it will work in the short term, in which case the problem just becomes greater sometime in the future.

And the greatest error is to think there is a solution other than allowing the problem to work its way out in its own good time. If ever "do nothing" was the right approach, it is now.

A very political pension

It is hard to understand how we reached the current position of Sir Fred Goodwin and his unfeasibly large pension. For anyone who doesn't know the background, Sir Fred was the head of the Royal Bank of Scotland until late last year. Under his stewardship a successful bank was reduced to a pile of steaming debt, posting losses of £24.1billion in the latest financial year. His bank was at risk of folding in 2008 until the government stepped in with vast sums of money and propped up its sagging cadaver. As part of the rescue package it was thought best for Sir Fred to concentrate on mastering crochet and flower-arranging, so his exit from the bank was negotiated. As with all negotiations, his departure came only when both he and the government were satisfied with the terms agreed. He did not insist on being paid in lieu of notice and he gave up certain other entitlements, including his key to the executive lavatory, in return the government thanked him and asked him to close the door on his way out.

The government had two other options. One was to let the bank fold, a course which would have terminated Sir Fred's contract of employment and restricted the amount of money he could get out of the company in the future, but that was thought unacceptable. The other was to sack him and let him sue if he didn't like it. There is only one good reason for not sacking someone who has overseen the total collapse of a previously successful business, and that is that you cannot prove he broke the terms of his contract of employment. Sir Fred was sought out by the bank to be it's big cheese. One consequence of being head-hunted for a major position is that you are very much in the driving seat when it comes to the terms of your employment. It would not be at all surprising if his contract of employment was drafted in terms very favourable to him. Indeed it might well be that his only concrete obligation was to receive his salary and bonuses. Various other obligations would be implied by law even if not expressly included, but each of them would be a difficult basis on which to justify dismissal even for the man responsible for snapping the bank's spine in two.

All this should have been looked into when the government took a majority shareholding in the bank and had to decide what to do about Sir Fred. In fact, even from this most incompetent of governments, it is inconceivable that it was not looked into. A deal was done and that was that. Sir Fred visited the yarn shop and started the crocheted blanket of his dreams. Now news has broken that his pension entitlement is no less than £693,000 a year for life, he is currently fifty years old, and the government is embarrassed. I have to say, I would be embarrassed if I had negotiated the removal from office of someone who had done so much damage and had managed to leave him with a pension pot valued at some £16million. I would ask how I could have been so incompetent.

An exchange of letters has now taken place between Sir Fred Goodwin and Lord Myners, the minister responsible for the negotiation. Sir Fred pointed out that he gave up the equivalent of more than a year's fat salary, that the pension was all recorded on the books and that the minister agreed to him keeping it. In reply the minister said he had believed the pension to be a legal entitlement whereas it now appears it was only discretionary. With the level of skill enjoyed by only this government in the western world, a minister's excuse makes him appear even more incompetent.

When the negotiation was taking place Sir Fred had a legal entitlement to a year's notice yet he agreed to forgo that entitlement, he had a legal entitlement to other benefits and agreed to forgo them, so why would the fact that the minister believed his National Lottery sized pension to be a legal entitlement mean it was not up for negotiation? It makes no sense.

But that's not the worst bit. The worst bit is that the minister did not know the legal status of the pension arrangement. These things are not written in hieroglyphics, they are contracts in pretty standard English legal jargon. They include a chunk setting out the terms on which the pension is payable. If you want to know what it means, the conventional technique is to read it.

None of this is to say that Sir Fred cannot be deprived of his ginormous pension, although it is very unlikely. Poor Gordon, at his most monocular and moronic, has started shouting about seeking ways to prevent at least part of it being paid. Even the grossly over-pensioned John Prescott has weighed-in, calling for Sir Fred to be summarily deprived of the money and putting the onus on him to sue for it. Not for him the rule of law or the law of contract, the idiot Prescott has votes to win so he wants to make the law up as he goes along if he thinks it will result in little crosses against the names of Labour Party candidates come election day.

It's all just political posturing, of course. If the government is to have any chance of undoing the arrangement within the law they face an enormous obstacle in their agreement to the severance package negotiated last year. Obviously we cannot tell exactly what happened. Maybe Sir Fred was given a generous pay-off because of his years of loyal service to the furtherance of poor Gordon's grand economic plan, and this little spat is the price he has to pay for his future income. Maybe he felt he had given up enough by waiving his notice period and other benefits and would never have agreed to cede his pension without a legal battle he felt confident of winning. Maybe the whole negotiation was just conducted utterly incompetently by a government that was in full headless chicken mode at the time. Whatever the true position, one simple fact remains - a deal was done.

And that is where the really important lesson comes from this farce. If it had been Barclays Bank or HSBC that took over RBS rather than the government, there would be no row about Sir Fred's pension arrangements. They would have been part of a the whole takeover package and lost in the small print while the real business of trying to rebuild a once thriving bank would be the only concern. Instead the state of the bank has been relegated to secondary importance behind an issue of no real consequence to anything. That is what happens when governments take over businesses. Headlines and opinion polls are more important to them than the substance of the thing. OK, so his pension pot is worth £16million, a huge amount of money for an individual, but what is it in relation to RBS as a whole? Its losses for the year were £24.1billion and his pension entitlement grew over several years, but let's treat it as a single part of the £24.1billion loss in that single year. £16million is 0.067% of £24.1billion. Heap all the vitriol you want on the man, he had to go, he had presided over ruination, get rid of him. Pay him 0.067% of the losses the bank incurred in his final year and send him on his way, it will be money well spent. Just start running the bloody thing properly.

Yet they will not run it properly. They will run it for political gain. They think there is political capital - by which I mean potential votes - in shouting about how much the failed former boss of the bank is being paid. They might be right, but it's got nothing to do with anything. If they were really concerned about it as a matter of high principle they could have written clauses into his severance contract ensuring he did not receive that money. The issue has cropped up now as a matter of pure political convenience. Just as poor Gordon is getting flak from national and international figures about the way he bankrupted the country he has found a subject to divert attention. It won't divert it for long and in a few weeks or months there will be another scapegoat put up to receive public fury, anything to prevent the government that bankrupted the country being identified as the cause of our bankruptcy.

We saw earlier in the week how Northern Rock is now to be used to make home-purchase loans for political reasons (here). Today the effective nationalisation of RBS is the excuse for trying to win some votes by bashing a man with money. Tomorrow it will be something else. There are endless ways in which attaching government to business allows politicians to engage in populist rants by picking a random example of how the business works, taking it out of context and flogging it for all it's worth.

Oh, and lest you might believe that I approve of Sir Fred's pension arrangements, I don't. But I would rather see contractual arrangements upheld than arbitrary rule according to the temporary direction of the political wind. Maybe we have laws to hold reckless incompetents like Sir Fred Goodwin to account for the vast damage they do, maybe we don't. Maybe that will never be tested. But I would rather he got away with scamming £16million under a freely negotiated contract than we have rule by populist diktat.

Now, let me see ...

A number of prominent news stories crossed my mind today as I watched England's cricketers limp and hobble their way to failure in Antigua. My thought-process was: Antigua - cricket - Stanford - anti-terror laws - banks - Madoff - MPs' expenses.

Nothing is as big in Antigua as cricket. For those who don't follow these things, England were scheduled to play a match against the West Indies on Antigua's new ground last week but it had to be abandoned after a short period of play because the ground was unfit. To the enormous credit of Antigua's cricket authorities a replacement match was arranged at very short notice on the island's old ground, and it is that match that ended today with England snatching a draw from the jaws of certain victory. Antigua's greatest living hero is the retired cricketer Sir Vivian Richards, a man of fearsome talent who graced the professional game for about 20 years from the mid 1970s. Sir Viv was knighted in 1999 under the system of honours set up by his home country the previous year.

There are not many Antiguan knights, another is a fellow by the name of Allen Stanford. Sir Allen Stanford has dual citizenship, being American by birth and having adopted citizenship of Antigua & Barbuda in later life. He holds a lower rank of knighthood than Sir Viv, which might explain why The Times refers to him as Mr Stanford. He hit the front page of The Times today as a result of having got himself into a bit of a pickle with his accounts. All sorts of allegations are being thrown around but the only thing that is known for certain is that no one seems to know what has happened to the money paid to his financial and banking businesses. Time will tell whether he has also been in the baking business and has been cooking the books. Sir Allen Stanford rather enjoys cricket and has sponsored some vastly remunerated tournaments. That, however, would appear to be all in the past because the US financial authorities are investigating his businesses and have frozen his assets.

For more than a day Sir Allen was nowhere to be seen. Noted for his keenness to be photographed as well as his love of cricket, it seemed somewhat odd that he was not lording-it-up with Sir Viv and the rest of the West Indian cricket glitterati, but champagne and dolly birds were there none. He'd done a runner. Where had he gone? No one knew. It can't have been the US because their impeccable anti-terrorist border security systems will have made it instantly apparent that he was there. Ah, woops. He was found in Virginia as the result of a tip-off. When discovered he was served with legal papers relating to the freezing of his assets and of those of his businesses. One of those businesses is the Stanford International Bank which boasted of making extraordinarily large profits for investors year-on-year. Once rumours circulated of the investigation by the US authorities there was a run on the bank and a number of governments had to intervene to stall claims while investigations continue into whether it is a Northern Rock with bad investments or a Ponzi scheme with no investments.

Obvious parallels are being drawn with the recently-exposed Madoff fraud. Whether there is a true comparison will only become apparent later in the course of the enquiry, but what is clear is that nothing is clear. Nothing is clear because the accounting practices adopted by the Stanford Financial Group's accountant (allegedly a one-man firm operating from a small office above a fish and chip shop) were not concerned with transparency. Lack of transparency does not itself cause fraud, but it does allow fraud to go undetected. Madoff took advantage of this for years, as did many fraudsters before him.

It's not just fraud that can remain hidden where rules do not require absolute financial candour. Similarly, the need for candour in financial dealings is not just so that fraud can be eliminated. Companies insist on receipts to back up expenses claims because they only want to pay for expenses that were actually incurred and they need to be able to prove those expenses further along the accounting chain. That they also want to ensure their employees are not cheating them is part of the story, but only part of it. The other part is the need to ensure money is being spent for proper purposes. And that's how my brain arrived at MPs' expenses.

If ever there is a proper use of the phrase "if you have nothing to hide you have nothing to fear" it is in relation to "expenses" payable by the taypayer to those who sets the levels of tax. Transparency is the only way to deter jiggery-pokery.

Here are your conclusions, now go and investigate

Well well, what a surprise. The government is going to launch an "independent" investigation into how banks are managed, so the BBC tells us. There seem to be no plans to look into how haulage companies are managed, or estate agents, or clothing manufacturers, or fish and chip shops or saunas & hanky-panky parlours. Just banks. Why? And why now?

Investigating how certain businesses are run is a perfectly legitimate role of government. There have been many such investigations over the years and for many different reasons. Perhaps there is a suspicion that a cartel is operating and keeping prices artificially high to the detriment of the consumer, or that company law regulations are being breached or taxes being evaded; all sorts of potential wrongdoing can justify an investigation. The common theme always is a concept known as "the public interest".

That term is used in various different contexts to mean different things. In relation to business it covers three things: law-breaking, unfair trading and business practices which cause structural problems to the economy.

Although it is not widely known, the Companies Court has the power to order the winding-up of a business for acting against the public interest. It is a power used to protect the public from cheats and spivs who appear to be running legitimate businesses but are in fact misleading or manipulating people in a dishonest or otherwise unfair way. I recall it being used a few years ago to wind up a company that appeared to be offering a roadside recovery service but had no trucks or contracts to use trucks and, on close examination, the contract gave the company an absolute discretion whether to send out a recovery vehicle at all. It wasn't a fraud because the contract was clear (at least to a lawyer), but it was misleading and the whole operation appeared more geared to refusing assistance than giving it, so the court wound it up to protect the public.

Applications to the court in such cases are made by the Department of Trade (or Business, Enterprise and Regulatory Reform as it is now so absurdly named) in its capacity as a regulator of good business practices. To my mind that is an important function which, perhaps, could be carried out by a non-governmental body, but I have no objection to it being done by a government department provided they keep politics out of it. The reason they must keep politics out of it is that investigatory powers and powers to take action against those who appear to be misbehaving are powers of law enforcement not law-making. Enforcing the law, in a fair society, should be impartial and aplotical. For decades they have had no difficulty keeping politics out of it because governments of both parties have accepted this basic point.

One aspect of aplotical impartiality is that investigations launched by government departments into particular businesses have been concerned primarily with seeing whether existing laws have been complied with. Government has no legitimate function in assessing the efficiency of individual private businesses, that is for the directors and shareholders to consider. So what is this new investigation going to look at?

The report suggests one area is "the extent to which financial incentives encourage bankers to take risks". Call me simple if you will, but I fail to see how any useful conclusion can be reached about the effect of financial incentives (ie bonuses) generally by looking only at one type of business. Nor can you discover anything by looking at specific transactions that you cannot already infer by applying a bit of common sense. You don't need to investigate anything to be able to infer that bonuses payable on the current paper value of business you write will cause people to try to maximise the amount of business they do unless there are countermeasures operating against that incentive.

Any individual banker faced with a decision whether to lend or not lend will be influenced by the desires of his employer. These are contained in formal documents outlining lending criteria: "thou shalt not lend more than 75% of the value of the property offered as security, thou shalt not accept a valuation except from a surveyor holding the qualification of Membership or Fellowship of the Royal Institution of Chartered Surveyors, though shalt not accept proof of the income of a self-employed applicant other than ..." and so on. If these criteria are sound then the total value of business written doesn't matter and no incentive by way of bonus can do anything other than result in increased good business. On the other hand, if the criteria are too lax and leave the bank open to risk, bad business will be done and incentives to increase the amount will also result in an increased amount of bad business.

There. That's the investigation done for them. My invoice is in the post.

Bonuses do not and cannot define the quality of business done although they can influence the quantity. If a bank does not have sound lending criteria it will make bad loans. The relevant question is not what effect bonus structures have, it is what role the regulator should play in circumscribing lending criteria. There is a public interest here, namely the benefit to the whole economy from having a stable financial system. It is, therefore, legitimate for government to investigate causes of instability. What is not legitimate is to hone-in on one of the two forces governing the amount of lending undertaken while leaving the other out of account. In other words, an investigation into the management of banks is so far wide of the mark it will be a waste of time and vast sums of taxpayers' finest.

It has already been made clear what conclusion the government expects the "independent" investigators to reach. It is set out in terms by Mr Darling in his remarks quoted in the BBC article. He is reported as having said "people feel angry about excesses of bank bonuses". There we have it, the conclusion has already been reached, banks have been paying excessive bonuses. Game set and match, thank you and good evening. That is not to say I do not believe bonuses to have been excessive. My belief is that they have been obscene because they have resulted from doing bad business rather than good business and, as far as I am aware, they are not liable to be recouped when risky loans turn sour. That is absurd and, I suspect, is in part the result of bankers believing the government's constant assurances for the best part of a decade that the economy was on a path of irreversible real growth and nothing would turn sour again. More fool them.

If there is to be a formal investigation into what went wrong it must cover all relevant factors. The way banks were managed is only a small part of the picture but it is the one from which the government thinks it can gain the most political capital. Why has it not been announced that there is to be an investigation into false claims that boom and bust have been abolished, or into the failure of regulation of lending criteria, or into Credit Default Swaps and the other ways in which risk was passed back-and-forth and multiplied? It's obvious, because there is no possible chance of gaining votes from the result of the investigation.

What has been announced has nothing to do with the public interest. It is pure party politics and, as such, is an abuse of power.

Bank bonuses and the Royal Albert Hall

All sorts of people are getting very excited about bonuses. Whether here or in the USA if there is a hint of a bank employee's current contract including a bonus structure bile is spewed like never before. How dare they pay bonuses? It's an outrage! Send in the dogs!

Now take a deep breath and ask yourself two question: (1) should a company honour existing contracts with its employees and (2) how would you draft new employee contracts to incentivise your staff?

All existing contracts containing bonus clauses have to be honoured. It is as simple as that. You can bleat all you want about how those terms should never have been agreed, but if they have they must be met.

Well-drafted new contracts have to reflect the needs of the company as well as providing a proper wage for the job in order to ensure you secure the services of necessary staff. A business that is going through a hard time and has to reduce losses or limit future losses might think it appropriate to pay a basic salary combined with a bonus scheme that pays an additional sum if losses are reduced or restricted to a predefined level. It might or might not work. Maybe the employees will have no effect and the level of losses in the year will be what they would have been regardless of what the staff did. But maybe their efforts do result in a diminution of losses, in which case they have provided a benefit far in excess of any bonus they are paid. No one can tell for sure whether such a bonus scheme will achieve anything but it might, and the job of management is to decide whether it is sensible to take that gamble in the long-term interests of the company.

There is nothing inherently unfair or corrupt in companies paying bonuses to staff in accordance with predetermined criteria. It might, in individual cases, be a bad move because circumstances can change and the bonuses might prove to be disproportionately expensive for the business. For example, a bonus calculated by reference to turnover will be payable if the defined turnover is met regardless of whether costs have increased to such an extent that the additional turnover produces no additional profit. On the other hand, a bonus calculated by reference to turnover will not have to be increased simply because the additional turnover produces more profit than anticipated.

If you choose to pay bonuses in addition to a basic salary you take a chance on those bonuses being affordable. Maybe they will be and maybe they won't, that's the gamble you take by following that path. In most instances the alternative is to pay a higher basic salary with no bonus. You are then obliged to pay the full salary regardless of how well your business does. Maybe it will be better for your balance sheet to pay people a fixed sum of £25,000 rather than £20,000 with the chance of a bonus of up to £7,500, maybe it won't. You have to decide what will work best for your business.

Objecting to bonuses simply because they are bonuses makes no sense at all. Because financial institutions were noted for paying huge bonuses during poor Gordon's boom of doom, there has developed a school of thought that bonuses are somehow inherently evil. It is utter nonsense. Indeed it is such utter nonsense that it is even more nonsensical than those bonus schemes which paid massive amounts on the assumption that all business written would be profitable in the long term. But you cannot reverse time. Stupid decisions were stupid decision, they were taken and have been acted upon. Move on and learn from the mistake.

Objecting to bonuses simply because they are being paid in the financial services industry is equally absurd. They are also paid in numerous other types of business up and down the country and at every level of employee. It is for each business to decide for itself whether to have a bonus structure, and if so what it should be.

More interesting is why people think it is their business to comment on the staff pay arrangements of financial services businesses when they would not presume to offer an opinion on the bonuses payable to Mrs Char, the cleaner and tea-lady at Madam Fifi's Sauna and Hanky-Panky Parlour. Some of the comment is just general observation about the way big businesses operate. Fair enough, that's all fine sport. But much more is comment based on the false belief that it is now the direct business of the commentator. That is what nationalisation and part-nationalisation of businesses does in a developed political system. It gives taxpayers the belief that they are now part of that business and that their opinion is necessarily valid. This belief is encouraged by misleading terms such as "public ownership" (when effective ownership is not with the public but with government ministers), it is also reinforced by the company in question becoming part of the political landscape rather than being just a business.

Of course, once something becomes a political football new forces operate. No longer are business decisions required to be taken on business grounds, now they have to be taken according to the political mood of the time. Are there votes for the governing party in a nationalised industry doing X rather than Y? If so, you find it is encouraged and, if necessary, coerced into doing X regardless of how good X is for the business itself. This influence is all the stronger in the run-up to a general election when the governing party is behind in the opinion polls.

You would have to search far and wide, and then abandon your search, if looking for a government politician who will say "They have to pay these bonuses because they have contractual commitments to do so." Yet that statement sums the position up in the shell of a nut. Where the top tier of bank employees has a contractual right to receive bonuses because their contracts were drafted when poor Gordon's boom of doom was in full swing, political bullying has the potential to force them to forgo their unmerited additional payments. And the difference it will make to the bank will be less than a gnat's fart in the Royal Albert Hall.

Sustainable debt, the only practical course

Far more regularly than we might like to admit, we all face problems we have not encountered before. The first illness of the first child, the first time something arrives on our desk at work and we look at it thinking "oh dear, I don't know where to start", the first dripping tap or rotting window sill encountered as a homeowner with no landlord to call on for free help, the first time we exit Madam Fifi's Sauna and Hanky Panky Parlour to see our dearly beloved looking in the window of the shop next door. We have to decide what to do. We can try to tackle it ourselves (usually more in hope than expectation that we will find the right solution) or we can call for help from those who know more about the subject than us (or, in the last example, we can go back inside Madam Fifi's establishment until the risk has passed). What would have us committed to the local asylum, if such a thing still existed, would be denouncing other people's suggestions and then announcing publicly that we haven't got a clue what to do.

Welcome to the world of Gordon Brown. He has now admitted that he is stumbling around in the dark and simply guessing at how to deal with the current banking crisis.

Now let's go back about a year. At that time it had become clear that big banks in the UK and America had been making a lot of very bad loans and off-loading the risk to others, then buying the risk taken by other big banks. It was plainly a complete dog's breakfast. No one knew how much each bank was likely to lose by the time all the bad loans clucked home to roost, so each bank at risk manned the barricades and sought to limit their new business to very safe and secure transactions. While all this was going on, a few big banks had not engaged in the risky stuff and a lot of small banks, with shareholders who keep them on their toes, carried on as they had for decades lending only to good risks and keeping a perpetually beady eye on how each loan was performing. These prudent lenders have carried on much as before and are in just as sound a position today as they were before Mr and Mrs Ordinary first heard the term "Credit Default Swap".

The real problem with the international banker's beano in Davos is that it was an international bankers' beano. They are big wigs, grand fromages, doyens and doyennes with medals of all colours and nationalities to confirm their position as the banking creme de la creme. The politicians are scared of them because they have real power whether or not they deserve it. They can make or break their customers and they can make or break national economies. That necessarily means they can make or break political careers. It would take a true statesman to stand up to them and say "you made a right balls-up of this and now you must pay". Yet the only real power they have over politicians is the power of blackmail and that is diluted by the banks' current parlous states.

I have been hoping to hear a leading politician call their bluff and say to the banking aristocracy: "we are prepared to help you out to a limited degree but we require every penny of that help repaid with interest and you must cut your suit to match your cloth". You see, these banks are not doing us any favours by staying in business. They are not doing so because they think it is in the long term interests of Mr and Mrs Ordinary in Stoke Poges. They are staying in business because they think they will make a stonking great profit a few years down the line. If they thought they were irredeemably bust they would not stay in business, they would fold and let the losses lie where they fall regardless of how that affected any particular country's economy. In fact they know that a well run bank is a steady source of decent profits and a speculatively run bank can deliver massive short-term profits but only at the risk of long-term losses. That is the position they are in now. They speculated and appeared to win for a while but in doing so they build up a catalogue of debt which has proved to be corrosive. It is no surprise that it is corrosive, that has been proved time and again in the past and that is precisely why prudent bankers have never chased speculative short-term profits.

The reason they are fighting to stay in business is the very reason why taxpayers should not take on any of the risk that currently lies on their books. Either the banks will make profits from the business they are doing now or they will not. The business they did in the past has been done and cannot be reversed. It is tolerably clear that there are substantial losses in the system from that business, some of it has already surfaced and a lot more is waiting in the wings. Those losses have to fall somewhere they will not just disappear. There are only four possibilities. First, the losses are kept on the banks' books and are made good out of future profits. Second, the losses prove too heavy for the banks to bear and they fold, in which case investors in those banks lose the value of their investment (be it as shareholder or depositor, but subject to the £50,000 taxpayer-funded guarantee or personal deposits). Third, the banks are relieved of the debts by the government taking them on, in which case they still do not disappear they have to be made good from future taxes. Fourth, the government takes on the losses subject to a right of reimbursement from the banks' future profits.

None of these options is attractive, but that is unavoidable because vast losses are unattractive. The only difference between the first and second options is the future profitability of the banks concerned. Either they make it through the mess they have made or they don't, if they do the first option applies if not the second comes into play. I am attracted to these options because it will mean the gamblers have to take the risk inherent in their gambling. But there is a problem in piling all the loss on just one link in the chain of responsibility. The banks are not the only party to blame in this awful situation. Their activities were subject to supervision by the Financial Services Authority acting on the instructions laid down by poor Gordon when he was Chancellor of the Exchequer. Those of us with a bee in our bonnet about banks lending money to people who cannot afford to repay it get rather miffed to hear the government condemning irresponsible lending. The government was responsible for supervising the banks and, one might think, part of responsible supervision is to prevent irresponsible lending. So, why should the loss all fall on the banks and their investors when government is also to blame?

If we are to be fair about these things we have to accept not only that government was partly to blame but also that we, the electorate, put the government in place. I certainly didn't do so but I am bound by the decision of a general election, and long may that be the case whether or not I agree with the particular outcome. So, if we are to be fair, part of the loss should be borne by the great British public because the incompetent shower they placed in office are also to blame.

How much, then, should the taxpayer have to bear? This is not a matter for an arithmetical formula, it is a matter for looking at the thing in the round any trying to reach a balanced view. Already the taxpayer has taken out massive debts to help the banks restore their capital position and now we are in a recession hitting the little man hardest. It will be a long time before graphs start to turn north and by that time the taxpayer will have been landed with previously unimaginable amounts of debt. That seems a pretty fair price to me. From now on let the banks sink or swim. The level of business they do will determine not only their ability to make good losses on bad loans but also the extent of borrowing the people of this country can sustain.

Forget credit-funded stimulation of the economy, concentrate on what can actually be afforded. There is no point pretending we can live on credit to the level we did in 2005, 6 or 7 and seeking to boost lending back to those levels. If we can't afford it, we can't afford it. If we can afford it, that amount of credit will be advanced. That is not a decision for government it is a decision for individuals, businesses and prudent bankers. If the banks need a further kick-start by some of their losses being guaranteed with an obligation on the banks to repay anything the taxpayer has to fork out, then it can be considered as and when that position is reached. As I said above, they are not in business because they think they will continue to make losses, they know that they can make good profits if only they make good loans rather than bad loans; so any further financial assistance should come with protection for the taxpayer.

Oh dear, how much this time?

Seconds out, round two, ding-ding. The battle of the banks moves into another phase. Last year the government handed over £37billion to help stabilise them but now a different problem has arisen, or to be more exact the same problem for a different reason. Last time there was a threat of imminent collapse through the banks being under-capitalised, now the threat is imminent collapse because of ... good question, because of what exactly?

It seems to me there is only one thing that can cause the collapse of a bank and that is an obligation to pay money when they don't have enough money to do so. We saw that problem when there was a run on Northern Rock. At the moment there does not appear to be a threat of imminent claims for payment which cannot be met, the perceived threat seems to be longer term. Our old friend Mr Toxic Loan is back in the headlines again.

I waffled on about him back in the summer, but a brief re-cap might be helpful to those who were listening with insufficient assiduity. If a bank makes a loan of £100,000 to allow someone to buy a house it expects to be repaid by the borrower over twenty or more years. Because too many loans were made without sufficient evidence of the borrower's likely ability to repay, many people borrowed money they simply could not afford. That brings the value of the house into the picture because serious default by the borrower leads to the bank seizing the house and having to sell it to recoup its losses. Too many banks lent too high a proportion of the perceived market value of houses and those properties are now worth less than the balance owed. To make things worse a massive merry-go-round operated by which banks and other financial institutions bought and sold the right to receive the income from these bad loans and a right to share in the proceeds if the houses had to be repossessed and sold. Thousands of loans were bundled up into batches and sold as a job lot, then re-sold in whole or in part over and over again. All sorts of people invested their money in funds which depend on these bundles of loans to provide a profit.

The current problem is that no one knows how much of each bundle comprises bad loans. They might have bought identical interests in two apparently identical bundles, one of which is going to be substantially loss-making and one of which is going to be substantially profitable. There are so many individual transactions involved that you simply cannot look at one bundle and try to assess the viability of each loan involved. Even if you tried it would take many months and a lot of guesswork. The only practical way of approaching the problem is to take a stab at the total value of loans made without checking the borrower's means, take a stab at the total value today of the properties used as security for those loans, assume the levels of default will be at the high end of historical averages and calculate what percentage of current worldwide outstanding loans this represents. It's little more that a wild guess and everyone knows it. All the financial institutions with fingers in this rancid pie are being treated like pin-less hand grenades.

As and when the bad loans go into default two consequences follow. First there is no income from the borrower, so a bank that advanced £100,000 expecting a return of 5% a year suddenly has no return on that investment. Secondly, the amount recovered on sale of the house might be less than the amount advanced. So, having invested £100,000 the bank might receive only £80,000 leaving it to dip into its capital to keep its books square. And, of course, there are knock-on effects. Because the bank was receiving income of £5,000 while the borrower was making the repayments it used that anticipated income as cash-flow from which to make further loans to other people. When the source of income dries-up so does a source of funds with which to make new loans, thereby causing a reduction in the bank's ability to do new business and, with it, a likely reduction in next year's income and that for some years to come.

One little discussed aspect of the credit-crunch is the startling effect increased defaults can have on the ability of a bank to lend in the future. Not only is there a shortage of income which would have been available to advance elsewhere, but the need to keep their capital reserves at a safe level means that they have to use income from performing loans to top-up their capital when a defaulting loan results in a capital loss. In the example I gave, the shortfall of £20,000 reduces the bank's capital by that amount so they have to use the equivalent of one year's income from four similar loans just to put cash back in the safe. And so the shrinkage of available funds to lend carries on until such time as the balance of its investments is steady again.

There is no magic way out of this problem. The defaulting loans will cause losses which will have to be paid somehow. If you want the banks to continue lending as though they did not suffer a drop in income, you have to relax the capital requirements. If you want to retain the capital requirements, you have to accept that they have less income from which to make new loans. Less income from which to make new loans means a lower total value of new loans, which means less money sloshing about in peoples pockets and less spending. Less spending means shops, importers, manufacturers and service industries have less income, which means less spending by the people involved in those businesses, and so the cycle progresses. This is the difficulty facing the government when deciding what to do next.

They know they have to insist on banks being properly capitalised because one effect of the government regulators relaxing capital requirements in the past was the massive expansion of bad lending. But they also want to take such steps as they can to prevent the vicious cycle of recession accelerating out of control. Their chosen course appears to be to reduce banks' overheads and give insurance against existing customers' defaults.

Part of the bail-out last summer resulted in injections of capital on which the banks have to pay interest at, I believe, up to 12%. Inevitably this means the banks have to use income from customers who do pay them in order to service that debt, thereby reducing the amount of cash the banks have available to lend. The government appears to be prepared to change the basis of that capital injection by taking a larger shareholding in return for dropping the requirement that interest is paid on the money injected. In other words they will reduce the banks' overheads by reducing the government's income from the banks. This could be a good deal for taxpayers provided the additional shares taken by the government increase substantially in value once the banks are doing additional business and the government then sells the shares at a stonking profit sometime in the not too distant. It might work. The one thing it should do is increase the amount of money banks have available to lend, thereby increasing their chance of returning to trading profitability. That of itself will help the public finances.

Insurance against the risk of default on existing loans is a far more difficult issue. The banks will have to pay a premium for that insurance. How, I wonder, will these additional overheads stand against the reduced overheads caused by removing the need for them to pay 12% on last summer's capital injection? We will see the details shortly, but it is a tricky balancing exercise. As I understand it, this part of the new plan will not increase the banks' ability to lend in the short term because it will not give them any more cash. What it will do is help to repair their capital position when loans default so that they do not need to use as much of their own income to restore their reserves of capital, instead the taxpayer will chip-in. To my mind the crucial question is what method, if any, will be included to allow the taxpayer to recover this money in the future. If there is no such mechanism, this scheme will amount to a potentially massive gift to the banks and an equally massive burden on future taxpayers. In fact it will be an even more massive burden on future taxpayers because the government is borrowing the money and laundering it through an inefficient bureaucracy. This measure is potentially far more expensive than any benefit it could produce.

I have commented before on the failures of regulation which allowed the banks to get themselves in such a mess and on the abject failure of the banks and their shareholders to do what they should have done to prevent the current problem arising. But we are where we are and the issue today is what, if anything, should be done about it. To my mind the one thing that should be at the forefront of government policy is that future losses as a result of past bad business cannot be avoided. They will surface, if not today or tomorrow then next week, next month or next year.

Simply transferring those losses to the taxpayer is not only bad for the economy generally - because higher taxes to pay for them will stifle the creation of wealth for a long time to come - it is particularly bad for those at the bottom of the economic pile. They are always hit hardest by increased tax because (i) there are more of them (so £1 from each is worth a lot more to the Treasury than £10 from each wealthy person), (ii) a higher proportion of their income is spent on taxed purchases and (iii) it is easier and cheaper to collect it from them than from those with the means to find legitimate ways to reduce their tax bill.

One option the government should not leave out of account is allowing the banks in the worst positions to fold. If they do fold, the loss will fall on those owed money by the banks. Mr and Mrs Ordinary will have their savings protected up to £50,000 per bank and that will be a loss borne by the taxpayer. Beyond that, shareholders who have gambled on bank shares producing either an income or capital growth will find they put their chips on black rather than red. So be it, that is the chance they took knowing they were gambling. Other financial institutions will take a hit when there is no money to repay them, just as The Amalgamated Plasterboard Company Ltd takes a hit when Fred Bloggs the builder goes bankrupt before paying their invoice. These risks are spread all over the world, British banks do not only have British investors.

I fear the insurance idea has a fundamental flaw. It guarantees that a proportion of losses will remain at home when otherwise they would be spread around the globe. Say a loss is made of £1million and 80% of the bank's shares are owned by Brits. That loss will cost the British shareholders £800,000 and £200,000 will be borne elsewhere. It might not mean an immediate loss to anyone, but it will reduce the bank's capital which will have to be reimbursed from future income thereby reducing the profitability of the business and, in turn, both the income and capital value of the shares. If the taxpayer has to carry as little as 1% of the loss (£10,000) the shareholders bear £990,000, split £792,000 to the Brits and £198,000 to Johnny Foreigner. The total UK loss is increased to £802,000 (£792,000 to the shareholders and £10,000 to the taxpayer) and our friends overseas get a gift of £2,000 from our taxes. Of course we are not talking about losses of £1million but about potential losses of hundreds of billions. Voluntarily sucking a greater proportion of that into the UK's debit column doesn't seem a very sound way to bolster this country's finances.

If, as I suspect, the real fear is that things are so bad that one or more banks will fold without a cushion against the effect of Mr Toxic Loan's halitosis, taking a measure that will increase the proportion of loss retained in the UK seems extremely risky. Could the scheme make the difference between folding and remaining in business? No one can tell because the potential losses are so massive and where they will fall so unpredictable. I have a nasty feeling about this one.

How much are houses really worth?

If you want to know the value of something there is, in theory, a simple way to find out. Put it up for sale, advertise it as widely as you can and see what offers you get. If you do this with a television set or an ordinary piece of furniture you can be sure the offers will give a pretty fair reflection of the item's true value because there are no distorting factors to encourage anyone to offer more. Of course it is somewhat artificial to talk of any piece of property having a single true value because you can never expose it to sale to everyone who might want to bid or who might find some flaw in it that others have missed. Nonetheless, giving it fair exposure to a reasonable range of potential buyers will give you a very good idea of what it is worth in the real world.

An interesting twist of the recent credit boom is that it did not fuel price inflation in any field other than housing. In part this was due to increased consumer credit in the UK coinciding with increased availability of the very types of goods people wanted to buy on credit - flat screen tellies, computers, clever music machines and other electronic gadgetry. No scarcity of supply meant there was always another seller who would undercut anyone charging over the odds. Another popular purchase made with borrowed money was foreign holidays. The holiday companies knew an increase of demand was most profitably met by making more available rather than keeping supply static and trying to charge extra. In each of these fields low prices and readily available credit were only part of the story, keeping up with the Joneses also had an effect. Wayne had a flat screen telly, so Darren wanted one, Darren's mate Ryan couldn't be left behind, and so it went on. When it was only a few pounds extra a month on a credit card it seemed easily affordable.

In relation to housing, supply and demand operate rather differently. Obviously you can't turn on a tap in China and create loads of new houses and flats, equally obviously the decision to buy a house or flat involves many factors not relevant when deciding whether to upgrade your fridge. Once prices start spiralling upwards the whole thing becomes a self-fulfilling prophesy. You feel you must buy now because this time next year you won't be able to afford to, equally you see a potential profit over that same period and if you don't make that profit someone else will. Spending £5,000 of your £25,000 salary on interest seems less painful if you think you'll make a capital gain of a greater sum than you spend. We all know now that lending people four or five times their gross salary does nobody any favours in the medium to long term. Some of us have known it for many years because we saw the effect when it was done in the mid to late 1980s. Exactly the same happened then as now - lenders faced huge losses when borrowers defaulted and thousands lost their homes because they could not afford to keep paying such a huge proportion of their income in interest.

Every house and flat must have a true value, be it a precise figure or a bracket of a few thousand pounds. If that were not so there would be no talk of a house price bubble, but how can we know what the true value is and how much is artificial? It seems to me that the true value must reflect affordability. There are always ups and downs. Someone gets hit with a bit of bad luck and can't afford the mortgage any more. Banks take the occasional hit through a customer being unable to repay a debt. These are unfortunate incidents but are not signs of a troubled economy or of the country paying too much for houses. When the level of defaults increases to such a level that banks lose money hand-over-fist you know too much has been borrowed against too little security - the prices paid for houses and flats were not affordable and, therefore, those prices did not reflect true value.

One can analyse affordability in various ways, it seems to me there are essentially two elements to it. First, one has to ask what proportion of income can be spent on a mortgage loan without stretching the household budget so far that default is a widespread risk. Historically the banks restricted mortgage loans to two-and-a-half times the gross income of the main earner plus the gross income of any second borrower involved in the transaction and they required a minimum fifteen percent cash deposit. There is nothing very scientific about these figures, they just proved to be a good guide to what people could afford without stretching themselves too far. This just gives you a figure for how much people can afford to borrow, in other words it tells you what they can afford to spend. It does not tell you what they can buy with that money. The second stage is to look at what one might reasonably expect different people to be able to buy. There are starter homes - small flats and one-bedroomed houses in which one might normally expect to find young single people or young couples. From there you can look to modest two or three-bedroomed houses to which you might expect those young couples to move some years later when they earn more and need more space for children. Then there are larger properties with good sized gardens usually bought by those earning substantial incomes. However many categories of houses and flats you compile, the true value of each is what can be afforded by those buying that level of property for the first time.

For example, take a young couple earning £25,000 and £20,000 respectively. The amount they can afford to borrow is about £82,500 and they must put down at least fifteen percent of the price of their first property. That means they can afford a property costing about £97,000, call it £100,000. As a very general rule of thumb, in areas where those salaries are decent rates of pay for people of their age, £100,000 should be the true value of a modest starter flat. We don't have to go back further than about twelve years to find just that figure being the average price of reasonably sized nice one-bedroomed flats in the area of Islington in which I live. The same flats averaged over £250,000 in the Spring of 2007.

Then take a single doctor aged 30 who has just been made a partner in a GP practice and earns £50,000. He can borrow up to £125,000 which, with the required fifteen percent deposit, puts his purchase price at about £150,000. That is the benchmark for the type of property one would expect someone in his position to buy, perhaps a two-bedroomed flat in a decent road. I haven't designed these examples to relate to the environs of FatBigot Towers, it just so happens that £150,000 would have bought a very nice two-bedroomed flat in a quiet road this area as recently as about ten years ago. A good £350,000 would have been demanded in Spring 2007.

All sorts of other factors affect house prices. I am, however, sure that the strongest factor is the amount of money potential buyers have available to them. Something is only worth what someone is prepared to pay for it, and what anyone is prepared to pay is limited by the amount of money they have at their disposal. If, as I hope will be the case, banks and other mortgage lenders impose tried and trusted limits on the amount they are prepared to lend we should return to much lower house prices and, indeed, prices which reflect true value. They will be a long way below what they are today.

Balancing blame for the recession

When something goes wrong it is often easy to try to identify a single culprit. If what has happened has caused people pain or expense, having someone to blame somehow makes things better, especially if they are subjected to punishment. All those victims of crime who complain about their assailant receiving a light sentence would complain so much more had no one been apprehended and convicted at all because the fact that the guilty party has been identified and suffered some adverse consequences gives solace even where their punishment does not match the suffering they inflicted on others.

In some fields it is simply unrealistic to suggest that one person or organisation is to blame. The current recession is an example of this. Was it all the fault of the banks for lending to people who could not repay the loans? Of course not. Nor was it all the fault of the borrowers who should have known better, or the government who encouraged the illusion of borrowed wealth in order to further their own ambition for power, or the government appointed regulatory authority. All of these groups are to blame in different measures because each made very serious errors of judgment and the consequences for everyone are bad now and look set to get a lot worse before there can be a real recovery. (Although I say "banks", much of the worst lending was carried out by finance companies unconnected to banks, but I will use "banks" to describe all lenders for present purposes.)

One group which has escaped serious censure to date is the banks' shareholders. This is a curious omission because they were in a better position than government to see what was happening and take steps to prevent disaster. The most common structure of a company is pretty much the same the world over and is based on a system devised in this country over a hundred and fifty years ago. The company has directors who are responsible for the day to day management of its operation and shareholders who put up the capital with which it operates and hope to make a profit from the company's activities. Shareholders have great power, if only they choose to exercise it. They appoint directors and can pass resolutions requiring the directors to do (or refrain from doing) certain things. Where the business practices followed by the directors are patently risky (like 125% mortgages or failing to investigate the means of the borrower) that risks falls on the shareholders not the directors themselves (obviously directors might also be shareholders, but that does not alter the substance of my point).

So what should you do as a shareholder in such a situation? Essentially you have two options: licking your lips and grabbing the profits while they are being made (then, if you have any sense, selling your shares before the excrement hits the fan) or taking steps to bring the directors' activities under control with an eye on the long term. Take the first option, as banks' shareholders did, and you are as much to blame as the directors themselves.

In saying this I don't pretend it is easy for shareholders to secure the majority required to pass a resolution forcing directors to change tack. Many shareholders are only interested in immediate profits not in the future, still less do they feel compelled to consider the effect on the wider economy of the business that is reaping them a nice reward. Even those who are sure a big mistake is being made know the easier option is to sell their shares rather than try to change the way a massive business is being operated. In all this there is a type of shareholder who really should have known better, the institutional shareholders with a duty to look to the future, in particular pension companies. A great many pension companies hold shares in banks because they have been a safe historic investment producing a steady return.

Pension companies are themselves huge businesses, administering vast sums of money on behalf of those who will call on them for income when they retire. There are some people who invest a lot in pension funds and build up a pot of a million pounds or more, in some cases many millions. A far greater number put a little aside every month, maybe a hundred pounds or so, to give a modest boost to their basic state pension when they finish work. It goes without saying that 1,000 people investing £100 a month is the same as one person investing £100,000 a month, it's an awful lot of money however it arrives in the pot and it has to be invested sensibly to give the best return over a lengthy period. Pension fund managers know they have to spread the risk they are prepared to take, so they invest some in rock-solid investments with relatively low returns (such as government bonds), much less in fairly risky ventures which might make a packet or might fold tomorrow and most in solid long-term performers like banks. The precise balance they choose to strike between risk and return differs from fund to fund, but shares in banks loom large in almost all.

Shares held by pension companies represent a large proportion of the total number of shares issued by many banks, which means that the pension funds have the muscle to influence the way the banks do business. A pension fund owning, say, five percent of the shares in a bank has great power, far greater power than a five percent shareholding might suggest. If they are worried about the way the bank is doing business and start selling shares they can cause the price of shares to plummet. Some selling is part of the natural way of things and rings no alarm bells, the sudden sale of a lot more than average suggests the bank might be in trouble and causes others to sell just in case there is a problem. Such an event causes a problem in itself and the banks know it. Large shareholders can have a huge influence over how a bank does business if they express concern about lending practices. They won't do it publicly unless they have to and they won't do it at all if they fail to appreciate the need for concern.

One might think pension funds and other very large shareholders would have found a way to get the banks to avoid taking undue risks, after all there were plenty of warnings in financial circles about the difficulties that could result from loose lending. All to often, though, the pension funds fell into the same trap as the banks themselves, they looked only to what they can make this year without consideration for the damage their own business could sustain a little way down the line. No doubt one factor in this was the whopping bonuses payable to pension fund managers if they made a big profit this year, bonuses which would not be recouped if a loss is made next year. That cannot, it seems to me, have been the only factor. There was also the simple fact that the banks were making a lot of profit and to make a move which would result in that profit being lowered would be harmful in the short term to the pension funds those managers had to administer. Even those who saw difficult times ahead could, perhaps, be forgiven for thinking that difficult times would affect other potential investments more than bank shares.

Despite all this, institutional shareholders must look to the long term in order to protect the funds they are running because pensions are a long-term business. Most of their customers will rely on them for more than fifteen years of investment returns before they retire, so jam today is only part of the equation the question must always be asked whether tomorrow's menu will feature jam or humble pie.

The failure of institutional shareholders to exert influence on banks was not just bad for the banks it was bad for the funds those shareholders administer. Their duty to their customers was to protect the funds and if that meant getting heavy with the banks they should have done exactly that. I know it is easy to say this with hindsight but I do not speak with hindsight, I speak with foresight because the problems caused by lending too much against too little security was exposed, painfully, in the early 1990s. During the latter part of the 1980s we saw 100% mortgages and borrowers only having to say they earn £40,000 a year for a bank to accept it and make a loan. It was exposed as appallingly bad practice not just by the housing crash from 1990-1992 but also in a long series of cases in the courts in which banks sought to recover their losses from solicitors and valuers who were alleged to have been negligent in their work during the course of a house purchase. Time after time the damages recovered by the bank were reduced substantially because they contributed to their losses through negligent lending practices. Many an eminent judge accepted the evidence of experienced expert witnesses and concluded that lending without proper assessment of the borrower's ability to pay was a recipe for default.

Those cases were publicised throughout the banking and pension industries, yet within ten years the same thing was happening again. The banks should have known better and so should the pension funds. I think it's time they took their share of the blame.