"That turned out to be spectacularly wrong. "

Peston on BBC:

"The Governor of the Bank of England didn't pull out the stops to cheer us up in his speech last night.

What was particularly striking were his closing remarks, when he said that he was sure an economic recovery would come and that there would certainly be a positive outcome from all those interest rate cuts and the hundreds of billions of taxpayers' cash allocated to pumping up the wilting banking system and stimulating demand.

But - and it's an important qualification - he couldn't be sure when the economy would turn. He said: "No one can know at what point the impact of all this stimulus will have a visible effect on activity; the lags in economy policy are notoriously long and unpredictable".

Oh dear. If the economists we trust to steer us through this mess ever had a torch, the battery appears to be flat.

Nor did I feel particularly reassured by his assessment of when the great cause of our woes will be fixed, the reduction in borrowing and lending by banks and other financial institutions.

To remind those who don't live and breathe bankers' jargon, when Mervyn King talks about "leverage ratios" he means the relationship between a bank's debts and its capital resources. He said that the "leverage ratios of large banks remain at remarkably high levels and the required adjustment will not happen quickly... With fresh capital from the private sector difficult to obtain, banks have opted to reduce their lending and that is why the flow of credit to all parts of the economy, here and abroad, has been heavily disrupted."

It's that stress on the leverage ratios of banks still being "remarkably high" that slightly surprises me. Not because it's wrong. But the Treasury and the Financial Services Authority have frantically been trying to reassure the banks that they have ample capital resources to finance their balance sheets - and Mr King does seem to be saying something different( TRUE ).

Mr King went on to say that "banks are encouraged to run down their capital to enable them to absorb losses while continuing to lend, but in the long run they will need more capital".

Again, this is not quite what the FSA is saying. The City watchdog's message - which it repeated loudly on Monday - is that our banks currently have enough capital to absorb the losses they'll incur as the recession causes increasing difficulties for borrowers. It says that their capital ratios will still be at acceptable levels even after the losses have been absorbed.

But if the Governor is right that banks have inadequate capital for the long term, the markets will price that in today, in the form of lower share prices for banks and much more demanding terms for the credit they require( TRUE ).

Considering the mullering of bank share prices in the past couple of days, it looks as though the Governor is right. But I doubt the Treasury or the FSA will thank him for pointing it out.

It's not all gloomy news, according to King. He says that because so much of banks' excessive lending and borrowing has been with other financial institutions, there is "scope for a reduction in the leverage of banks without restricting lending to the 'real' economy".

There are two things to say about this.

First, as John Gieve, the Deputy Governor of the Bank of England, told me in an interview for my Panorama documentary before Christmas, the Bank of England was too sanguine during the boom years that there was some kind of cordon sanitaire around the debt and asset bubble, such that when the bubble was pricked it wouldn't infect the real economy too much.( TRUE )

That turned out to be spectacularly wrong. It's therefore reasonable to question whether the non-financial sector (that's you and me, and "real" businesses) can be protected from the massive reduction of lending between financial institutions.( A FAIR POINT )

Also, the way the Treasury is trying to protect the non-financial sector is by imposing formal quantitative targets for lending to businesses and households on those banks in receipt of financial support from taxpayers. As you've noticed, it's instructing the banks to lend considerably more to all of us.

Which is all very well.

But as I've pointed out before, if all countries forced their banks to concentrate their lending on domestic markets, that would lead to an even sharper fall in cross-border flows of funds and capital than is already taking place.

It would amount to a kind of financial protectionism, a beggar-my-neighbour policy, that could impoverish us a lot more than would otherwise be the case.( ANOTHER GOOD POINT )

So the Treasury should tread a little warily, I think, before forcing all our banks to do nothing but their patriotic duty.

PS: Mervyn King is at pains to point out that he hasn't run out of all tools to revive lending and the economy.

He confirmed that we're probably about to enter the relatively uncharted wilderness of "unconventional measures" to stimulate the flow of credit and money: what's called quantitative easing, or the creation of reserves at commercial banks by the Bank of England buying all manner of financial assets, in the hope that the banks won't just sit on these reserves but will convert them into loans to the private sector.

It's reasonable to see this as the creation of new money. The big question is whether it would circulate and stimulate transactions - which is what the Bank of England would want - or would be hoarded.( YES )

In fact, within a matter of weeks, we'll see the Bank take an imaginative first step in that direction, when it starts to buy up corporate debt (not for cash, but in exchange for Treasury Bills), in the hope that the liquidity of the market for corporate debt will be significantly improved and thus make it cheaper and easier for big companies to borrow.

This may sound tediously technical. But it is big stuff. It represents the public sector, us as taxpayers, lending directly to companies( TRUE ) (even though the Bank will be buying this stuff on the secondary market). "

It's wonderful capturing these moments of clarity and truthfulness by bankers. It has an almost sexual pleasure to it. Almost I said. Don't get carried away.

"who has admitted that interest rates are only a "blunt instrument" with which to control the economy."

A banker speaks. From the Guardian:

• Julia Kollewe
• guardian.co.uk, Monday 22 December 2008 11.29 GMT
• Article history

The Bank of England underestimated the severity of the current financial crisis, according to its deputy governor, who has admitted that interest rates are only a "blunt instrument" with which to control the economy( I AGREE WITH THIS, WHICH IS WHY OPPOSE ITS USE TO STOP BUBBLES ).

Sir John Gieve told the BBC's Panorama programme, to be screened tonight, that new tools were needed to complement interest rates. He also admitted that the Bank knew "crazy borrowing" was taking place and the price of houses and other assets was rising unsustainably, but did not fully understand the problem( IT SOUNDS LIKE THEY DID. WHAT WAS UNDERESTIMATED WAS THE SEVERITY OF THE CRISIS AND INEFFECTIVENESS OF GOVERNMENT INTERVENTION. I BELIEVE THAT HIS STATEMENT LENDS CREDENCE TO MY THESIS ).

"We didn't think it was going to be anything like as severe as it's turned out to be( BINGO! )," said Gieve, who is in charge of financial stability at the Bank. "Why didn't we see that it was so serious? I think that's because we, perhaps, we hadn't kept pace with the extent of globalisation. So the upswing here didn't involve the big increases in earnings and consumption and activity which we saw in previous booms. We saw the credit, we saw the house prices, but we did see a fairly stable pattern of earnings, prices and output."

Tim Besley, another member of the Bank's monetary policy committee, was quoted in the Daily Mail as saying there was "no quick or easy fix" to deal with the fall-out from the credit crunch and that measures other than monetary policy were needed( VERY TRUE ).

Sterling fell to a fresh record low against a trade-weighted basket of major currencies after the comments, hit by worries that British interest rates need to come down much further as recession bites( THEY WILL ). The euro climbed 1.5% to 94.72p, taking it close to its recent record high of 95.56p, which has led to the expectation that the two currencies will soon reach parity.

More powers needed

Explaining why the Bank did not raise interest rates to curb the lending and house price boom, Gieve said: "If we'd used interest rates to try and address this asset-price credit growth, we would have been holding down the level of activity elsewhere in the economy, in manufacturing, in other services, holding down the level of employment at a time when consumer price inflation and earnings were stable and reasonably low. And people would have said, you know, 'this is a wilful reduction in the prosperity of the country'."( WHAT HE JUST SAID IS WHAT I'VE BEEN SAYING )

The Bank could not rely only on interest rates to control the economy, Gieve argued. "One of the main lessons from this is that we need to develop some new instruments which sit somewhere between interest rates, which affect the whole economy and activity, and individual supervision and regulation of individual banks," he said. ( I AGREE )

"Maybe we need to develop something which bridges that gap and directly addresses the financial cycle and prevents the financial cycle and the credit cycle getting out of hand... I think we need to complement interest rates, which are a blunt instrument – you set one interest rate for the whole economy – with something which is more financial-sector specific."( I PREFER SUPERVISION OF THE INVESTMENT INSTRUMENTS, AND A STRICT FOLLOWING OF BAGEHOT'S PRINCIPLES )

Philip Shaw, chief economist at Investec, said the comments suggested that the "authorities recognise that more needs to be done to restrain borrowing booms because they are potentially destabilising." He noted that there had been numerous comments by Bank officials previously stating that interest rates could not be used to rein in borrowing because they were mainly designed to keep inflation on target.

Among the measures being considered by the government – to be adopted once the economy recovers – is a requirement for banks to hold more capital during good times( THIS MAKERS SENSE IF GOVERNMENT GUARANTEED ). Other measures could include legislation or guidelines on lending to households, Shaw said.( NO SPECIFICITY )

Gieve defended the Bank's performance in the crisis, which he called "a major storm we haven't seen the like of for 100 years". ( WE COULDN'T HAVE BEEN EXPECTED TO SEE IT COMING OR BEEN PREPARED TO DEAL WITH IT )

"It would be very surprising( SURPRISE ME ) if we weren't learning lessons from it and we are," he added.

Gieve also cast doubt( WAS REALISTIC ) on whether the Treasury would get all of the money back that it had poured into the banking sector, pointing to a "level of defaults" in the books of nationalised lenders Northern Rock and Bradford & Bingley, which were now held by the taxpayer.

Speaking on the same programme, John Varley, the chief executive of Barclays, predicted that consumers and businesses would struggle to get access to credit for the next one to two years."

There are some good points made here.