What Does Osborne’s 'Credit-Easing' Really Mean?

When chancellor of the exchequer, George Osborne, got up to speak at the Conservative party conference on Monday, he knew he had to tread a fine line between optimism that the British economy could recover and wasn’t going to fall into a "double-dip" recession, versus facing down calls from the Liberal Democrats to ease public spending cuts and those on the right of his own political party calling for an end to the 50p tax rate at the very least.

Chancellor of the Exchequer George Osborne holds Disraeli's original budget box as he leaves 11 Downing Street for Parliament.
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It wasn’t an easy task, but he just about managed it. However, he did so in a rather contradictory and confusing manner.

There were really no new announcements in the chancellor’s speech; what we got were mostly policies that we already knew were coming or -- in the case of freezing Council Tax -- the same policy for a second year in a row. It also happened to be a policy that would save the average UK family a grand total of £1.50 per week!

The only new policy announcement was, of course, that the government would pursue begin "credit easing"  -- except that unfortunately this wasn’t a new policy either. (More about that later.)   For the next hour or two after he first used the term, political journalists at the Conservative party conference were left scratching their heads, trying to work out what credit easing actually meant.

What they were told by Treasury officials was that it amounted to the government buying corporate bonds from small- to medium-sized enterprises (SMEs) – effectively lending those businesses the money they need to either grow and expand, or simply stay in business, because the banks still appear reluctant to do so.

Apart from the idea being a tacit admission that Project Merlin, the government’s agreement with the banks that it won’t hit their compensation bonuses next year if they manage to lend several billion pounds to SMEs this year, was not succeeding sufficiently in its aims, the policy represents a number of problems for Osborne.

Worse still, it shows that the cuts in UK government spending are ideologically driven rather than based on sound finance. The credit-easing policy idea also raise s  a number of difficult questions that, as yet, the Treasury hasn’t been able to answer.

The first of these, and the most obvious, is where is the money to lend to these businesses going to come from?

So far the coalition government’s plan to reduce the structural deficit doesn’t really appear to be working. Public borrowing hit a record high for the month of August, which suggests that either the chancellor isn’t really getting his sums right or increased public borrowing is becoming necessary to pay for automatic stabilizers such as jobseekers' allowance and other benefits.

Journalists briefed by Treasury officials on Monday were told that the credit-easing scheme could lead to tens of billions of pounds being lent to SME’s. But how is the government going to be able to lend this money to small businesses when it tells the public that it doesn’t have the money to maintain police office numbers? Will it have to increase public borrowing in order to lend the money to business? And if so why borrow to lend to business and not to keep hospitals open?

Following on from this initial problem, there are various other questions that need to be addressed and about which the government is presently fairly hazy.

These questions include, who will qualify for these loans? How will the Treasury or the Bank of England – which is thought likely to manage the scheme on behalf of the government – decide which business is deserving of a loan and which isn’t? How will an SME be defined? Will it be a company of five individuals, a sole trader, or will there be a qualifying number of staff, say 100? 

Will SME’s have to provide profit and loss accounts for the last five years? Will they have to submit business plans to show what they are going to do with the money?

Apart from all these questions -- and they are just a sample of the many that have so far been left unanswered -- is the inherent risk in lending any money to small businesses. It's why so many banks are refusing to do so. Many of them fail.

So this raises even more questions such as how will the government recoup its losses from those that do? Will it ever be able to? And if not, what will be the efffect on public finances? Will further cuts become necessary because the Treasury took a gamble on a whole bunch of small businesses that went belly up?

The above questions is and that specific inherent risk of SMEs failing is why the Bank of England’s governor Mervyn King rolled back on Alistair Darling’s same policy proposal two years ago, telling the then-chancellor that he had no real problem with the policy itself except that because it involved risking taxpayer’s money it should be the elected government that took that risk. I told you it wasn’t a new policy.

So when the chancellor said yesterday that borrowing an additional five, ten or 20 billion pounds for public spending would put at risk the UK’s credit rating, what did he really mean? This is where the ideology comes in.

Osborne is a believer in the idea that business will flood into any gaps left by reduced public spending, and if not, then volunteers will – this is the core belief of the Conservative party’s often-mocked Big Society program. Close a village library, or threaten to do so, and either the private sector will step in to run it or the village will come together to raise enough money to keep it open or run the library off the back of charitable donations. And so on.

What Osborne tends to ignore -- apart from the fact that in deprived areas the community may struggle to keep its local library open because they're so busy just trying to keep their heads above water -- is the fact that a lot of businesses, as well as banks, all over the world, right now are hoarding cash whatever their size, and as a result are unlikely or unwilling to fill the gaps left by the government.

The problem is that, if those of a more entrepreneurial persuasion are unable to secure the funds they need to set up businesses, or are too busy shoring up their balance sheets to take on the risk of further investment, then the services once provided by the government simply disappear.

Such gaps in the economy have a negative impact on growth. So is Osborne offering a way of funding the public sector by the back door?

I suspect so. I’ve no proof that this is going to be the case, but given past Conservative policy and the fact that both the chancellor and prime minister consider themselves the heirs to previous prime minister Tony Blair’s public sector reforms, it wouldn’t surprise me.

The only way we’ll know if I’m correct will be to see which businesses are the recipients of these loans. But personally I suspect restaurants, for example, won’t be among them.

Osborne’s policy is based on the theory that the government will one day get its money back from the loans it makes to these small businesses. In the meantime, the private sector will bring market forces and competition to outdated methods of providing public services.

Osborne is still spending the money he suggested yesterday he would not. He just doesn’t want anyone to think he is.

And by dressing it up as a loan to small businesses, he is able to maintain the argument that the government is reducing government waste and overspending on services that he believes are in desperate need of reform.

It seems to me to be one very large gamble and I’m not entirely sure it will work. In fact, I fear it will simply mean that most people in Britain will end up paying more for poorer quality public services that have been channelled toward the private sector, all through the back door.