Tag Archives: #BlackWednesday

Fairy dust the magic ingredient that makes for successful policy making



fairy dust – Fairies Photo (17694885) – Fanpohttp://www.fanpop.com

Economics is a subject that is never related to the childhood world of fairy tales, yet Tinkerbell* and her magic dust is a useful concept to use in economic analysis. I can illustrate this with reference to the financial crisis of 2008/9. Everybody knows that the government borrowed the billions of pounds to bail out the banks, but very few understand how the government borrowed that money. It was in the borrowing process that drops of magic fairy dust were applied, it might seem strange to apply such childish concepts to economic policy making, but they are apt.

When the government borrows money it does it by issuing government bonds, which are then bought by members of the financial market. Those members of the financial markets which buy these bonds are the banks and those banks included the those that are receiving the bail out funds from the government. It may seem surprising that banks such as the Royal Bank of Scotland and Lloyds which were literally bankrupt could buy these bonds, however virtual bankruptcy is not quite the same as actual bankruptcy, so there was no bar on them buying bonds to raise the money, which would then be given back to them as part of the bail out loan. This is where the magic comes in, when a bank uses its bad money to buy government bonds, what it gets back in return is good money. It as if the government had sprinkled fairy dust on to the bad money to transform it into good money, much as Cinderella’s fairy grandmother turned the pumpkin into the coach.
Just as Tinkerbell only comes back to life when all the adults in the audience shout out that they believe in fairies, the government’s magic only works as long as the people  believe in it. This financial sleight of hand only works as long as the public believe.  In countries such as Greece where this belief has long since disappeared this type of conjuring trick would be impossible.
What is little realised is how important ‘fairy dust’ is in economic policy making. A good example is the bank rate. Bank rate is the rate of interest which the Bank of England charges on loans that it makes to other banks. It is the rate at on which all banks base their interest rates, their rates are the Bank of England rate plus a percentage add on. This way of calculation interest rates seems very sensible as it is common sense to add a mark up to a loan to cover the cost of borrowing money in case of trouble from the central bank. However most financial institutions are ineligible to get loans from the Bank of England, so it’s a convention or a fiction, but one which is widely believed. The belief in this fiction is so strong that the monthly setting of the bank interest rate once a month is believed to be the key determinant of the level of economic activity. If the rate goes up it is believed that this will effectively slow down the level of economic activity and prevent the economy overheating. As if this one key rate goes up all other interest rates go up so borrowing becomes more expensive, so individuals borrow less and demand falls and so in consequence does inflation.
However some doubt must be cast on this policy as Bank rate has been at near zero for the past five years and economic level has been at its lowest level for decades. Yet cheap money should mean demand rises, as money is cheap to borrow and the economy should be experiencing record rates of growth. Obviously something is missing and that missing item is economic fairy dust, businesses and people have stopped believing in the magic practised by the economic policy makers.
Perhaps the best illustration of this is Black Wednesday in 1992, when the Chancellor of the Exchequer North Lamont increased the central bank interest rate from 10% to 12% and then to 15% in an attempt to stop the speculators from selling the pound. These speculators by selling the pound were trying to force the pound down in value to make a profit. He lacked credibility as there was no ‘fairy dust’ making his policy credible. All he achieved was to nearly bankrupt the UK. By the end of the day he admitted defeat and said that the pound sterling would leave the European currency union and no longer be fixed in value in relation to the German Deutsch mark. The pound fell like a stone in the money markets and the speculators were able to buy cheaper pounds in exchange for the dearer pounds they had sold earlier. (The government had guaranteed the value of the pound sterling in terms of Deutsch marks, so all the speculators had to do was sell their holdings of billions of pound sterling at the rate guaranteed by the government, forcing it dispose of most of its holdings of foreign currency to pay the speculators. If the trade in pounds had gone on for much longer the countries foreign currency reserves would have been exhausted and it would have been bankrupted.) The point I am trying to make is that is not the policy that matters but the belief in the efficacy of the policy and the policy makers. If the market does not believe that the policy makers possess economic ‘fairy dust’, the policy will not work. 
Giving a more contemporary example Britain’s economic growth rate is well below its trend rate only averaging 0.7% a year. If Britain’s manufacturers really believed that the Chancellor possessed that economic magic miracle maker fairy dust the economy would be booming. Last week 100 top industrialists wrote a letter to The Daily Telegraph, stating how important it was that policies of the coalition government were continued because it was the road to economic recovery. Yet there very actions demonstrate the reverse, investment in British industry is at a record low as is productivity, by any rational measure of economic success the UK economy is still failing. Business leaders whistling in the dark will change nothing.
Our political leaders lack the skills that successful politicians need, that is the ability to make people believe in them. The mockery with which our politicians are subjected to in the media is not a product an age that  believes in nothing but the product of any leading politician to give the people anything to believe it. They offer various varieties of the same story to a sceptical public who sees it not working, yet politicuans believe that by endlessly repeating the same formulas people will believe and things will improve. In desperation the British people are turning to political mavericks such as Nigel Farage in the belief that they possess the magic. Unfortunately success only comes from good policy plus magic not magic alone.