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Dear Eddie
We note with some concern that last month, the first for some time in which the Labour Economic Policy Group did not make a submission to the MPC, was also the first for some time in which you went wrong by opting for "wait and see" instead of continuing the process of interest rate reduction.
We, therefore, reiterate our view that the reduction process must go on with a two percent reduction this month as a prelude to further reductions to take our interest rates below the European rate as fixed by the Eurobank. You should also proclaim your intention of taking and keeping British interest rates there. Why should our rates be higher than theirs when inflation is much the same?
As we pointed out in our last submission, your policy to date has been based on a simplistic model derived from the days of manufacturing, of wage pressures causing inflation. Still preoccupied with this out-of-date picture the MPC (like all predecessor regimes) has kept interest rates too high, keeping Sterling at too high a level, inflicting deep damage on manufacturing and shrinking our industrial base further and faster than that of any other comparable country.
These policies are justified by a series of theoretical arguments, none of which are true, all of which compound the damage. These are :-
(1) Higher interest rates reduce inflation. In fact they increase it.
(2) There is a rate of Unemployment which does not accelerate inflation. In fact when it comes to marginal changes the two are largely independent of each other, though any fool can bring inflation right down by putting enough millions out of work.
(3) There is a natural rate of inflation. In fact there is only the rate we want.
(4) The exchange rate must be kept up to avoid inflation. In fact it reduces production and productivity and increases unit costs and the burden of overheads and taxation on the base.
The result of these misguided strategies is an uncompetitive, low growth, inflation-prone economy crippled by real interest rates and an exchange rate, both of which are too high. As a result, manufacturing, the engine of productivity gains, and growth, is too small, a proportion of the economy, so we cannot pay our way in visible trade while services insulated from competition and, therefore, more interest and exchange rate immune, are over-dominant. So growth is slow, productivity increases lower and inflation higher.
Thus the Bank and the interests of finance have created a lopsided, stagnant economy dominated by low growth, high unemployment, and gaping trade deficits, then shackled it further by still keeping interest rates and the exchange rate too high. We have done an analysis of the American trends over the period 1977 to 1997 which brings the productivity consequences out. The American case is not as severe as ours because manufacturing has not shrunk as far as we have compelled it to do - in job terms from 19.7 million to 18.6 million - but the contrast between it and the service sector in respect of growth and productivity is clear from the following table and the consequences are exactly the same as here. Except ours are worse.
Output per Head Percentage Changes from 1977 to 1997
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Total Annual
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1997 Change Average
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Manufacturing
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81.4%
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3.0%
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Construction
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13.1%
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0.7%
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Mining
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83.2%
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3.1%
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Sub total
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56.7%
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2.3%
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Agriculture Forestry & Fishing
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201.8%
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6.7%
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Transport & Utilities
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36.9%
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1.6%
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Wholesale Trade
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88.0%
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3.2%
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Retail Trade
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22.7%
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1.0%
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Finance Insurance & Real Estate
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9.1%
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0.4%
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Services
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16.7%
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0.9%
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Government
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4.8%
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0.2%
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1997 GDP
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17.35%
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0.80%
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Source: Tables B.13, B.46 and B.100, Economic Report to the President, Feb 1999
Let us now take this stagnant economy with its higher propensity to inflation, in which production for the international market is nowhere near profitable enough, and ask what your interest rate policy should be. Since inflation is low, will stay low and will be brought lower by low interest rates, policy must be directed to getting the exchange rate down, bearing in mind that
(i) High real interest rates at a time when both Europe and the Far East are still uncertain bring money flows in.
(ii) The fact that the oil price is rising and may well rise further will put upward pressure on the Pound and downward pressure on the hapless Euro, making our competitive situation and our balance of trade vis a vis Europe worse.
(iii) Establishing a "docking" or entry rate with the ever falling Euro must begin very soon if we are to maintain relativities for two years prior not just to entry but to the decision about entry. We are still in the ERM bands. We cannot enter at this rate, or anything like it, without ruinous consequences.
It is essential in these circumstances that our interest rates are set lower than those of Europe. The need for this is increased by the accumulating evidence of gathering recession. Its impact may not be so great as we have feared (though no one can really say yet) but unemployment is rising, activity is slowing and the economy needs the boost that lower interest rates will bring. Similarly, long term survival needs the lower exchange rate which lower interest rates will bring.
Managing the economy for competitiveness rather than an inflation rate chosen at random must now be the central object of policy. Now that inflation is below your target you have to latitude to do this and should not be stopped by any fear that a more competitive exchange rate would lead to inflation. We have already provided the evidence that it would not: a productive, growing economy boosting living standards is the best defence against inflation. A declining, underun economy produces it.
As we have pointed out before, Macro policy is, in effect, in your hands. You may not like this. You may feel that it is neither your job nor the remit you have been given. But you must see that if you don’t manage Macro policy no one else will and adverse trends will compound. As they do the economy becomes more inflation-prone because manufacturing is such a small share of the economy, services so large, growth is lower but demands don’t abate and costs increase because capacity is under-used and resources of people and equipment are left idle, all increasing cost pressures. The lot of the semi-retired rentier economy in an increasingly competitive world is not a happy one. Yet a blinkered obsession with inflation which ignores the major issue of competitiveness leads inevitably to it. |
