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Dear Eddie
We regret that you did not accept our advice, and that of manufacturers, producers and probably the majority of sensible economic opinion, by reducing interest rates last month. Stability is not the outcome of stable interest rates in a declining situation. It comes from sensible adjustments ahead of time rather than driving straight ahead into a bend in the economic road.
So we repeat this month our advice to cut rates but with the added emphasis that the cut needs to be bigger because the later the adjustment comes, the bigger it will have to be. Interest rate reductions are necessary for a series of reasons. The most important, in our eyes, are:-
(i) The economy is slowing substantially. Company profitability has fallen heavily and is far too low. Investment is falling fast. Unemployment will soon be rising. The economy needs a stimulus. Tax reductions are not possible. Credit is over-extended. Interest rate reductions are the only stimulus available.
(ii) The pound, though it has come down slightly, is still substantially overvalued. Interest rate reductions are the only available way of encouraging it down and giving a signal to markets that the Government and the Bank want sterling lower. Instead we have a series of suggestions that rates can go no lower and that they will begin to go up next year. They won`t. It is a mistake to give such signals to markets. The pound will eventually fall heavily to bring the exchange rate into line with economic realities. You need to be in control of the situation by encouraging a more gradual adjustment rather than compounding the problem in the way you are.
(iii) Inflation is substantially below target and unlikely to rise. Indeed, the fears lie the other way being that a deflation is possible. There is a margin for reductions which it would be irresponsible not to use. Why should risk in the MPC always err on the side of excessive discipline rather than growth? “When in doubt deflate” is not a reasonable maxim to steer by in a growth-starved economy.
(iv) British interest rates are higher than those of any of our competitors, Europe, the US, and Japan. There is no understandable reason for this, particularly when our exports and trade are suffering in competition with theirs. Both the pound and higher rates constitute a substantial competitive burden compared with them and need to be reduced. We have a responsibility to the world economy to bring rates down too.
(v) There is no threat of inflation. We live in a period when inflation is dead for practical purposes. Enormous attention has concentrated on house prices, not just for price rises but also because of the growing concern that the house price bubble will burst. Neither the rise in house prices nor a bursting bubble are your responsibility. It is wrong to lose sight of your role and importance in managing the whole economy by focussing on these issues so obsessively. You have become too preoccupied with the financial froth and bubble and not enough with the state of the real economy of production and selling in a competitive world where, apart from oil, our situation is worse than any competitor. House prices are not in the RPI. They do not directly impact on your inflation target. If the rise needs to be checked only government can do it and there is no reason why the Bank should step into the breach.
(vi) What makes it your responsibility? Lower interest rates are not going to stoke further house price inflation in any substantial way, though they do make that which has already happened easier to cope with. If the bubble bursts then lower rates will be essential anyway. We cannot, therefore, see why high prices play such a substantial part in your deliberations, and even more in public discussion of your role. The same is true of consumer demand. It`s not your responsibility to manage it, be preoccupied with it or even damp it. Only government with its fiscal weapons can do that.
Your basic target is to keep inflation around 2.5%. You have failed to achieve this. Inflation has always been lower and has never shown any sign of breaking through the 2.5% barrier, though there have been indications that you might have to report failure to the Chancellor because it was substantially lower, indicating how deflationary your management has been. In this period of low inflation your elaborate attempts to manage inflation by continuous marginal shifts in interest rates followed by long periods of unimaginative clinging to a high rate are equally unimportant. Whatever you do, inflation is not going to be a problem.
That means that you should really have paid and be paying more attention to the rest of your rubric, particularly the health of the whole economy. Here neither the Bank nor the Government have been particularly successful. The economy has become seriously overbalanced to Finance and against production. Manufacturing is in its third big wind down and production is falling. More and more of it is being transferred overseas – indeed when call centres, the ultimate form of cheap white-collar exploitation, go overseas to be more profitable, the time has come to ask serious questions. Investment is abysmal, productivity is lagging badly, exports are flagging, the trade deficit gaping. In short, it is just not profitable to produce here.
This produces a continuous complaint from all sections of manufacturing, particularly engineering and motor car production. It leads some car manufacturers, more anxious than intelligent to call, misguidedly, for euro entry. This shows that they don`t understand the role of the exchange rate in converting our costs into prices in foreign currency on foreign markets. It naively assumes that we can lock into the euro with no ill effects, at this overvalued rate, when in fact it will lock us in forever at a high cost level and make this country unprofitable long term. The ignorance is appalling but the fact that it is voiced so long and loud shows how serious the problem is, even if the voices mistake its cause.
The main things currently keeping the economy going are the increase in public spending, working in an anti-cyclical way, the rise in house prices which allows money to be siphoned out to keep consumer demand up, and the credit explosion still going on. You can`t affect the first factor, though lower rates do facilitate more government borrowing. You can have a direct effect on the last two by reducing rates. Which is what you should do, particularly bearing in mind the fact that doing so will also help bring the pound down.
The prospect of sustained low inflation together with the changes prolonged overvaluation has produced in the British economy combine to produce a new economic ball game. In that the Bank will have to keep interest rates low and stop thinking it can either put up rates, or threaten to do so, without inflicting major damage. This is now a low wage economy because of the death of well paid manufacturing jobs. The fact that the financial bubble is also bursting and the City losing large numbers of well paid jobs compounds that. The government accepts that it has to supplement and hence legitimise low wages by family income credits. It is also a high credit economy, with a higher level of debt than any other except the United States. Both these facts mean that interest rate increases to manage the economy in the old-fashioned way are far more damaging, both socially and economically now than in the past. Even minor increases will burst the bubble, bring back negative equity, mean people cannot keep up with their mortgages and impose particular cruelty on the low paid and the poor, many of whom already bear a heavy burden of higher priced debt through loan sharks and none of whom can shoulder any higher burden. In such a society the only way interest rates can go is down. However much central bankers love higher interest rates and however much Bank Governors and inflation hawks (the birds with no prey) like to envisage rises and murmur about rates going up as if they were the Sadistic Dominators of a recalcitrant and naughty economy they cannot be increased. We are back to a post-war situation where money was kept cheap, except that now the market requires money to be cheap, where in the late Forties, until the Tories came in, it was government policy.
We make one further point which has a bearing on the need to reduce rates by the two percentage points we recommend. The Chancellor has recognised that his growth predictions were over-optimistic, something we pointed out at the time. He has reduced them for the year ahead. Yet he still sees an increase in the year after which will take us back to trend. This second improvement is unlikely and we may well undershoot his first, lower, estimate. What is now to boost growth? All the long list of factors reducing competitiveness and increasing our costs in overseas prices, particularly the high exchange rate, must eventually wreak their inevitable consequences, hitting exports and production and encouraging imports. An economy cannot be run forever on the basis of an untenable exchange rate, however hard Bank and Government try to keep it high. With the chickens already coming home to roost and consumer demand, which has kept things going, beginning to flag under the burden of debt, what is to produce the revival anticipated by the Chancellor? The Bank needs to ask itself this question when it thinks about interest rates.
We can see that revival may come in Germany with its powerful manufacturing base and that France and Italy will benefit from any reduction in European interest rates which is likely. Their export competitiveness is far better than ours but they are depressed by Euro-driven fiscal and monetary pressures. Ease them and they`re off. American growth is already benefiting from the reduction in interest rates there. Yet Britain has undermined its productive base so far so that even a greater degree of competitiveness now is not going to provide the same stimulus. It must be bigger than anything in the past to turn the situation round. The risk is that instead of being a leader in a resumed race, as the government boasts that we have been up to now, we will become the laggard in a new and faster one.
At that point it will be absolutely clear that very low interest rates are the only way ahead. The Bank will be forced into them. You should anticipate that, appreciate the depressing realities around and look ahead at all the heightened difficulties of the end game of the overvaluation era. Reduce interest rates now and substantially. We have been extraordinarily lucky, both as a country and as a Labour Government. Our luck is running out and was never, in any case, a sensible base for sustained policy.
Because of that luck the MPC has been given more credit than it deserved as a successful method of operation. In fact, it has had credit for low inflation which was happening anyway, and for a stability which was in fact a slow coast downhill. The reality is that it has been excessively cautious and now it is about to face more severe difficulties and a more testing time. It will find that canny caution and an exaggerated obsession with a dead enemy are no longer enough. |
