The Bank of England could only have staved off the "great recession" of the past five years if it had been given the power to rein in reckless lending by Britain's banks, Sir Mervyn King has said.

In a speech at the London School of Economics marking 20 years since the Thatcher government switched the focus of Britain's economic policy to battling inflation, the outgoing governor gave a robust defence of the Bank's performance in the runup to the crash in 2007, insisting that tweaking interest rates alone could never have prevented it.

Instead, he said the Bank should have been able to deploy "macro-prudential" tools, such as limits on how much risk banks could take on for a given level of assets – a so-called leverage cap, similar to the one that the government plans to impose when it implements the proposals of the Vickers commission.

"With hindsight, before 2007 there should have been a cap on the leverage of banks. And the cap should have tightened as asset prices increased and the likely exposure to losses increased. That is why we now have a macro-prudential policy regime in the UK."

King has urged the government to impose the stricter cap proposed by Vickers, instead of the weaker limit chosen by George Osborne after lobbying from the financial sector.

The governor also referred briefly to the eurozone crisis, saying the historical parallels with reparations debts run up by Germany after the first world war were "too poignant to dwell on".

The governor's speech came as the International Monetary Fund used its twice-yearly global financial stability report to warn that the world financial system was even more fragile than it was six months ago, with the eurozone's banks facing massive capital flight as investors move to protect themselves against a potential collapse of the single currency. The IMF's José Viñals said: "Faltering confidence and policy uncertainty have led to a pullback of cross-border private capital flows from the periphery – quite an extraordinary phenomenon within a currency union.

"This has driven up funding costs there to governments, banks, as well as for corporates and households, and, in turn, threatens a vicious downward economic spiral," Viñals said at a press conference to launch the report.

The IMF calculated that total assets of EU banks could shrink by as much as $2.8tn (£1.75tn), leading to a 9% reduction in credit in the eurozone's weak peripheral economies. In an "adverse" scenario, it said the banks could be $4.5tn short, causing a catastrophic 18% collapse in credit.

With the global crisis still ongoing, the Bank of England governor, who is due to step down next summer, issued a staunch defence of the benefits of targeting inflation, and sought to rebut the argument that the Bank's monetary policy committee should have shifted interest rates higher before the crisis, to rein in speculation and protect Britain from the crunch.

That would have been a risky approach, he argued, which could have driven the economy into recession, or strengthened the already overvalued pound still further, exaggerating the imbalances in the British economy.

"The case for price stability is as strong today as it was 20 years ago," he said, adding that to abandon inflation targeting would be to "throw out the baby with the bathwater". However, King argued that there might be some situations where it would be right for policymakers to "aim off" the inflation target in order to prevent a jarring financial or economic crisis.

He gave as an example widespread "misperceptions" by firms or households about their future income, in which they run up debts they are unlikely to repay. "If households extrapolated past increases in house prices into the future, then they may have mistakenly inferred that future incomes too would be higher, and so spending and borrowing more than could be sustained."

However, King suggested policymakers could not always identify such mistakes in advance. "Are central banks less prone to misperceptions than others?" he said.

Other cases where central banks might decide to "aim off" the inflation target might be where there is widespread over-confidence in markets, leading to mispricing of risk, as happened in the run-up to 2007; and where excessively low interest rates are causing investors to underestimate the levels of risk in the economy.

Contributors

Heather Stewart and Phillip Inman in Tokyo

The GuardianTramp

Related Content

Article image
Mervyn King urges banks to build up capital to protect against eurozone
The Bank of England governor tells UK banks that contingency against a worsening crisis should take priority over dividends

Larry Elliott economics editor

29, Jun, 2012 @3:53 PM

Article image
Sir Jon Cunliffe career profile
The new Bank of England deputy spent most of his career in the Treasury, and was a key figure alongside Gordon Brown in 2008

Phillip Inman

26, Jul, 2013 @4:25 PM

Article image
Mansion House speeches shed light on financial 'squeaky bum time'
Speeches by the chancellor and Bank of England governor show they fear for UK economy as eurozone crisis comes to a head

Larry Elliott

14, Jun, 2012 @8:00 PM

Article image
David Cameron calls summit with Mervyn King over Greek exit plan
PM and senior colleagues meet Bank of England and FSA chiefs to discuss how UK can protect itself from Greece leaving euro

Patrick Wintour

28, May, 2012 @6:55 PM

Article image
Can Mervyn King save the British economy? | Aditya Chakrabortty
Aditya Chakrabortty: The Bank of England governor is probably the man most responsible for getting Britain out of recession. So can he do it?

Aditya Chakrabortty

18, Jun, 2012 @7:00 PM

Article image
David Cameron warns of looming second global crash
PM says ‘red warning lights are flashing’ against a backdrop of instability and uncertainty, as G20 summit draws to a close

Patrick Wintour in Brisbane

17, Nov, 2014 @10:08 AM

Article image
Euro plummets after ECB warns currency zone may need more support
European Central Bank head Mario Draghi says Japanese-style stagnation possible amid high unemployment and falling inflation

Phillip Inman, economics correspondent

09, Jan, 2014 @6:17 PM

Letters: Challenges to a crazy economic orthodoxy
Letters: Capitalism needs managing and directing by progressive governments, otherwise it tramples people into the ground

23, May, 2012 @8:00 PM

Article image
IMF finds $11bn black hole in Greek finances and warns of new write-off
Recession continues in Greece as unemployment hits 27%, but flickering growth returns elsewhere in EU

Larry Elliott

31, Jul, 2013 @5:03 PM

Article image
Governing should be about democracy, say economists
Yanis Varoufakis is among signatories to a letter asking Britain and the EU to sign up to a nine-point UN code putting democratic rights – and not the market – at the heart of international governance

Phillip Inman Economics correspondent

07, Sep, 2015 @11:27 PM