I rejoice in UK Business Secretary Vince Cable’s ability to believe in two contradictory things at the same time. One is that the banks should strengthen themselves by putting more money into reserves. The other is that they should lend more to small businesses in order to kick-start economic recovery. The logical problem, of course, is that money which the banks keep in their vaults isn’t then available to lend out to businesses – or anyone for that matter.

In his Autumn Statement (or soon after), Chancellor George Osborne is expected to resolve this dilemma by providing government guarantees on loans that the banks make to certain businesses. It parallels his announcement last week that the government would provide guarantees on loans made to first-time house buyers.

Guarantees are cheap. You don’t have to shell out the money unless things go wrong. That doesn’t stop them being immoral and counterproductive. With the government guaranteeing 95% mortgages, and with interest rates so low, I wonder how many people will be seduced into taking out home loans which – when interest rates rise – they won’t be able to afford. Encouraging such sub-prime mortgages is surely immoral. And taxpayers bailing out banks when such loans go wrong…well, haven’t we been here before?

The business loan guarantees being planned by George Osborne pose the same moral hazard. And they are bad for business, too. Sure, credit is tight. Curiously, that might be because interest rates are too low, not too high. Why would anyone lend money when the interest they earn doesn’t even keep pace with our 5.2% RPI inflation rate? Inasmuch as the new guarantee scheme encourages businesses to borrow – which might be marginal, given the gloom that infects nearly all businesses right now – it will encourage people to make more bad investments. It’s surprising, but business failures are lower at the moment than they have been in decades: it’s simply cheap credit that is propping them up.

Some time, businesses have to grit their teeth and write off all the over-optimistic investments they made during the Brown Bogus Boom years. Then perhaps their investment cash can be put into things that have a better prospect of returning a profit. Painful, but better than living in a fantasy world underwritten by taxpayers. But giving them cheap credit, and more of it, just prolongs the the illusion, and the slow agony.

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blog/tax-and-economy/a-guaranteed-mistake