Accounting for banks: a new broom

George Osborne, the new Conservative Chancellor of the Exchequer, has moved very rapidly to reform financial regulation in the UK.

There can be little doubt that the old system has failed. As he prepares to deliver his emergency budget George Osborne must be very aware of the vast sums of money the previous government sank into Northern Rock, HBoS and RBS. The chancellor is set to embark on emergency measures to ensure that he is able to borrow the money that his government needs without spiralling into a debt crisis so he must be determined to avoid additional borrowing just to prop up failed banks.

It is to be hoped, though, that Mr Osborne is not being too hasty. There are lessons to be learned not just from looking at the history of our own rather ineffectual FSA but from other countries as well. The new government's plan is to replace the FSA with a Prudential Regulation Authority as part of the Bank of England along with a Financial Policy Committee. This will give the UK exactly the same arrangement as Ireland where the Central Bank and Financial Services Authority failed even more disastrously than the British regulators. Even the CBFSAI's own report cannot hide from the fact that it was, in effect, useless.

Nevertheless there is some reason to be hopeful. A fresh start was needed by the FSA, after all. Since Gordon Brown gave the Bank of England's Monetary Policy Committee control over interest rates it has shown good sense and some independence from political control. We might hope that the FPC and PRA follow that precedent. The climate in which the Bank of England does its business, though, is still set by the Chancellor. We will see later on today whether he is willing to put the lid belatedly on Britain's property price inflation that is its own particular contribution to worldwide financial instability.

For richer, for poorer

Today's news from the Office for National Statistics is that inflation in March had risen to 3.4%.

The Governor of the Bank of England, Mervyn King, has said that he expects this rise and that other pressures will bring the inflation rate down in time. This analysis seems more than cautiously optimistic but Mr King does not want to contribute to the looming possibility of stagflation by appearing to predict runaway inflation. His prediction is beginning to sound unrealistic because inflation tends to create its own spiralling effect and, now that we have a significant upward trend, the likeliest outcome is that inflation will drive itself higher. Many wage settlements will automatically reflect the increase in the Consumer Prices Index and retailers and manufacturers who are paying more for stock and materials do not have the margins to allow them to hold prices in check. The combination of price inflation with low interest rates may cause sterling to fall even lower. That, in turn, will mean that imports, particularly oil, will be more expensive and prices will rise still further.

The British, however, have always considered rising prices to be a good thing. We call it the "property ladder" and we are delighted when house prices seem to be going up and equally miserable when they seem to be falling. There is some justification for this. The "profits" we make on the increased value of our homes may be an illusion because we are destined to exchange each property for another that is equally over-priced but, as inflation marches onwards, we find that the real value of the mortgage that finances our home ownership diminishes year on year. If the whole process goes into reverse then thousands of people in the UK rapidly descend into "negative equity" because their mortage represents such a high proprtion of the puchase price of their house. So, in practice, inflation makes us richer. No wonder Mervyn King is content to allow prices to rise.

Yet that isn't the whole story. A few people in Britain have savings. They ought to be very unhappy to find that, even if they spend none of the interest on their accounts, their savings are rapidly losing value. There are also some poor souls whose wages are not rising with inflation. They, along with those living on savings, are rapidly getting poorer.

So, ironically, the national economic medicine that we are swallowing at the moment is rewarding anyone who has borrowed a great deal or is guaranteed a pay increase, regardless of performance, that corresponds to inflation but punishing all other workers and savers. It may be that there is no alternative to the Bank of England's monetary policy right now but are we really ready to lay the foundations of a sound economy for the future?