Here, just as in the rest of the UK, unemployment has risen sharply, and some of Scotland’s oldest and most proud financial institutions have been brought to their knees in the global financial crisis. That has highlighted the need for us to change the way we run our economy and financial system. We must grasp this opportunity for reform. If we do not, future generations will run a serious risk of having to face another financial crisis perhaps even more damaging than that of the past year.

But what should reform look like? To be successful, it must deal with the underlying causes of the crisis, rather than some of the more obvious symptoms. One such cause was the failure to ensure that banks and other financial institutions had the right incentives. At the heart of this problem is the “too big”, or “too important to fail” problem. Banks knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them. And they were right.

The sheer scale of support given to the banking sector over the past year is breathtaking. Direct or guaranteed loans and equity investments offered to banks in the UK amount to close to a trillion (that is, one thousand billion) pounds, around two-thirds of the economy’s entire annual output.

Having banks that operate on the assumption that they will receive taxpayer support if things go wrong is simply inconsistent with their being in the private sector. There are two possible ways forward. We could minimise the likelihood of these banks failing, thus reducing the need for the public sector to step in. Or we could find a way for them to fail without imposing unacceptable costs on the rest of society.

Neither option provides an easy answer. The first would require us to decide which institutions are “too important to fail”, a challenging task given financial markets are constantly evolving. And past experience suggests that no amount of detailed regulation will ever be sufficient to ensure that institutions can’t fail.

The second option might involve preventing banks from combining risky “casino” activities with the basic, utility-type services that they offer, such as providing customers with bank accounts and lending to households and companies. Financial institutions that carry out the risky business could then be allowed to fail without that having an impact on the services crucial to the operation of the economy. This too, has its challenges. For example, history has shown that governments, in the midst of a crisis, have not found it easy to stand behind only the basic services provided to the wider economy if that leaves a risk that the crisis might spread.

Whatever the path we choose, we must move away from the world where banks can take gambles, safe in the knowledge that they will be guaranteed by the government. That is the challenge facing us. There is an active public debate on regulatory reform. Solving the “too important to fail” problem must be central to that.

Of course, there are other long-term challenges that we will need to face if we are to return our economy to health. Most obviously, we must rebalance our economy away from spending -- both public and private -- and towards saving and investment. That is consistent with the necessity for us, as a country, to deal with the public deficit. But it is also consistent with the need for more balanced economic growth in the world economy -- with countries like ours selling more goods and services to emerging economies in Asia, like China, to help pay for all the goods we buy from them, rather than relying on borrowings to maintain our level of spending.

But we also face some important short-term challenges in guiding the economy out of recession and keeping inflation low and stable.

The Bank of England’s Monetary Policy Committee (MPC) sets interest rates each month to meet its 2% inflation target. At the moment, interest rates are extremely low, and the MPC has carried out a large programme of asset purchases, sometimes referred to as “quantitative easing”, to provide an extra stimulus to the economy. That is because the weakness in the economy threatens to keep inflation below the 2% target. I do not know for how long interest rates will remain so low. But at some point they will return to more normal levels and it would be wise to take this into account in your financial planning.

To decide on interest rates, the MPC needs the best information on what is happening in the economy. So most months, I visit different parts of the United Kingdom to talk face to face with businesses, and get a first hand understanding of current economic conditions. Other MPC members do the same. It also gives us a chance to explain our view of what is happening in the economy, and our policy decisions. This week, I am making a series of visits in Scotland. It is clear that Scotland, as the rest of the UK, is suffering from the consequences of banking failures. That is why it is essential to reform the structure and regulation of our financial system so that future generations will not suffer an even greater crisis.


Ratesetter supremo


Mervyn King is Governor of the Bank of England and chairman of the nine-strong Monetary Policy Com-mittee, which sets UK base rates.

He was previously deputy governor of the Bank from 1998 to 2003, and chief economist and executive director from 1991. King was a non-executive director of the Bank from 1990 to 1991.

Born in 1948, King studied at King’s College, Cambridge, and Harvard (as a Kennedy Scholar) and taught at Cambridge and Birmingham Universities, before spells as visiting professor at both Harvard University and MIT. From October 1984 he was professor of economics at the London School of Economics, where he founded the Financial Markets Group.

King is a fellow of the British Academy, an honorary fellow of King’s and St John’s Colleges, Cam-bridge and holds honorary degrees from Birmingham, City of London, Edinburgh, London Guildhall, London School of Economics, Wolverhampton, Cambridge and Helsinki Universities. He is a foreign honorary member of the American Academy of Arts and Sciences, is on the advisory council of the London Symphony Orchestra, is patron of Worcestershire County Cricket Club and is a trustee of the National Gallery.