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Dear Eddie
We haven’t been able to put the views of the Labour Economic Policy Group before your last two MPC meetings owing to absence in New Zealand. So a belated merry new Millennium. Please make it happier economically than the last with its low growth and miserable performance.
Sadly, however, without the benefit of our advice your committee has gone astray by two further, and unnecessary, steps down the road to deflation. These interest rate rises indicate to us that the committee are looking at the wrong issues and don’t understand what is happening in the real economy. Forgive us, therefore, if we explain our position in representations which are longer than usual.
Committee decision-making inevitably leads to fidgeting mini-moves and compromise decisions which end up by accomplishing little and satisfying no-one. Britain needs a long-term perspective and rates based on a realistic assessment of what is necessary in the real world of production with a concern to help the economy grow. Instead we get restless mini moves up, down, and now up again. This is unsettling, expensive and dangerous. It encourages uncertainty and speculation and creates a climate in which business finds it difficult to take rational long-term decisions.
It also makes it difficult to come to any judgment on the consequences of your actions. Each rise in interest rates is backed by the usual simplistic claim that a stitch in time saves nine but there is never an indication of where and how and since consequences of changes can emerge only a couple of years later we never know, and you can’t prove or tell us, whether fidgeting interest rates have produced any particular result. In economics ceteris is never paribus but on a priori grounds it is right to wonder what possible effects minor rate changes can have, and particularly what any quarter percent increase in rates does about escalating house prices in London, which is intermittently given as an explanation of increases, even though house prices are not part of your remit.
These are more than debating points since the Bank needs to be able to justify and explain what it’s doing if it is to work on a basis of rational expectations and predictable behaviour. Perhaps, therefore, we could make four points.
ONE You are using the wrong weapons and acting on the basis of outdated views of how the economy works and irrelevant fears about dangers which were relevant in past decades but are less so now.
TWO In trying to deal with a new situation by misusing the weapons of the past you are trying to fight a high-tech war with muskets pointed at your own side.
THREE The high exchange rate is your effective, perhaps only, weapon against inflation. This same policy did great damage in the early Eighties and Nineties. It leaves you with no alternative but to support the Pound with ever higher interest rates if the exchange rate shows signs of coming down.
FOUR The consequence is that Britain’s best opportunity to make up the ground we have lost by low growth and to expand and grow as the only real answer to inflation is being thrown away.
Let us take each of these issues in turn.
ONE The assumptions on which you seem to be acting are :-
- Lower unemployment means higher inflation. A return to the outdated Non Inflation Accelerating Rate of Unemployment theory which was discredited as American levels of unemployment fell and which, in any case, is irrational. Low paid jobs with no industrial power are hardly a problem and it is difficult to believe in the shortage of Labour or even skills when 1.7 million people are out of work or looking for it and large numbers of skills are unused because of age or "illness".
- Higher growth causes inflation. It ain’t necessarily so but depends on the assumption that staff and skill shortages mean inflationary pressures. Manufacturing is currently shedding skills, jobs are being de-skilled and lost at an accelerating rate, and much investment goes to this. It’s difficult to see why the assumption in Britain is that our economy can only grow slowly. Others, like Ireland, most of our competitors, even ourselves in earlier times, grew, and grew, much faster without inflationary disaster. Here the tiniest glimmer of growth produces frantic speculation that interest rates must go up, a climate which is hardly conducive to risk-taking or investment.
- Interest rate rises counter inflation. Not true of house price rises in London and the South East. Not true if you take into account the extra costs and higher charges imposed on everyone since they increase inflation. Nor do interest rates have any bearing on imported inflation such as rising oil prices. In any case, why are rates still going up when the inflation level (2.1%) is below your target of 2.5%? Why are all the risks you run on the high interest side, never the low?
- Inflation is a savage beast likely to run amok , unless tamed by regular interest rate lashes. This idea, a product of the inflationary Seventies and Eighties, is unsustainable today. Competition is intense. The world is awash with excess production capacity. New producers are flooding into markets. Domestic producers have little control over prices. Competition and cost cutting in distribution has grown. Unions and Labour are weak and workers insecure and anxious about their jobs. Labour has been substantially replaced. In such a situation inflation is low and will remain so but you constantly predict it rising, always erring on the side of caution not growth and go in for interest rate overkill, worse here than most other countries and more damaging than higher rates are in the powerful American economy.
TWO The greatest change and the one which makes your decisions so questionable today is that flows of money have now reached higher levels than ever before and the level of rates here is a particular attraction for parking funny money and waiting for appreciation. The flow is conditioned by expectations about the future prospects of a currency and expectations for Sterling remain high, partly because of the assumption, which you have generated, that rates will stay high. Money has been flowing out of the Far East and into UK and USA. So both currencies are unnaturally high, though the dollar’s level may be more sustainable (and less damaging) than Sterling’s . That is clearly influenced by interest rates. Witness the rises after your last increases. Yet it also feeds on itself and on the expectation that Sterling has further up to go, as well as money coming in to fund the trade deficit and purchase of assets here as British businesses fail because uncompetitive. We are benefiting both from speculative flows, which can leave as quickly as they come, and from the returning profits on our huge overseas investments.
All this is compounded by expectations about a Euro which has been managed downward, boosting the flows into Sterling. This devaluation against us gives EU exporting industries a competitive advantage which, if we sought the same by devaluation, would be criticised vociferously as unfair.
With the Euro low Euroland interest rates so much lower than ours to go on as you have, putting British rates up with no regard to the competitive situation, is completely irresponsible in a single market. How can you justify our interest and exchange rates being so much higher than Euroland’s? What studies have you made of the effects of their low interest rates on inflation rates, particularly in Ireland? This might illustrate the relationship between interest rates and inflation and will certainly demonstrate the excessive height of ours. In our view, it is difficult to justify monetarism in one country and dangerous to attempt it. Yet this is the essence of what you are doing.
THREE The consequences of high interest and exchange rates in an economy which trades as much as ours and has such a high propensity to import are very different to those prevailing earlier, or on the US. You are fighting inflation by keeping the Pound grossly overvalued to make imports cheaper and force British producers to shed Labour and cut costs in a vain hope of being more competitive. This is outward bound economics which may check inflation but only by inflicting long-term damage on our productive economy (though less in the service and Finance economy which you represent) and reducing Britain’s ability to grow because growth comes from manufacturing. You come close to avowing this in your assessment of UK trading prospects - portrayed as the main instrument in controlling inflation. That may be unpatriotic, damaging to British production and undermining the strength of the real economy. But is the essence of what you are doing. If we are not correct in saying this, please explain why.
This dangerous policy is now reaching higher levels of folly as the Pound approaches 3DM 30. In the view of some it could even go higher, though we would be interested in your views on this. If you feel unable to control inflation with the Pound at this level (a problem indicated by the last two rate rises) then what are the prospects for interest rates if and when the Pound comes down? This raises the question of your explanations for its rise and the expectations you have formed about its future course because you have changed both from time to time. But whatever the answers to this the Pound must, at some stage, come down, perhaps because the balance of payments, already deteriorating rapidly, becomes horrendous, something we cannot sustain in the way America can. Perhaps because the economy falters under the weight as we think it will or perhaps because investment decisions are reconsidered as our prospects dim, particularly as against Europe, its new entry states, the reviving Far East, or anywhere.
Then the Pound will fall. What goes up must come down. It may fall fast, or slow, no-one knows, least of all you. Yet any fall means that the Bank, having opted for high interest rates when the Pound was high, must go for even higher rates to counter the fall because of fears that a lower exchange rate means higher inflation. In our view it doesn’t for competitiveness is the only way to get economic growth, and expansion is the best weapon to reduce unit costs and inflation while importers will hold prices to keep market share. Yet orthodox opinion, bankers, pundits and those who have advocated and defended high rates will be palsied by fear and you will be driven, willingly or reluctantly, into attempting to stop its fall by still higher rates. The effect will be to minimise the benefits and the competitiveness arising from the fall.
FOUR The consequences of high real interest rates and a Pound overvalued by at least 30% are damaging for the British economy. We have already gone through two Tory blood-lettings with widespread closures of manufacturing and industrial capacity produced by exactly the same policies in the early Eighties and the early Nineties. It is claimed that interest rates were higher on both these occasions as nominal rates were, but that was in a world of higher inflation and today’s real interest rate is much the same as it was then while the Pound is still higher and well up on ERM levels.
The same consequences have not yet come through for a number of reasons. Producers are cutting costs and holding prices in a desperate attempt to keep market share, though both are finite processes and point to the inevitable collapse of the firms concerned, rather than to success in a tougher, more competitive, world. Many manufacturers are transferring jobs, work, component production and whole processes overseas and merely putting the finishing touches here. If that. The most vulnerable and weaker industries and firms went in the earlier shakedowns so those that hung on naturally have more staying power. All have gone through cuts and slimming down to make themselves more competitive but still can’t endure this forever. Anorexia eventually kills and hanging on in the hope of better is a finite process when it never comes. Particularly if it involves abandoning investment, research development, training and everything that makes for long term competitiveness.
The consequences of prolonged overvaluation aren’t immediate. They are inevitable. We are already seeing a major impact, particularly on the car industry. Indeed, the claims coming from some car producers, Mitsubishi, and other industries, that we must join the Euro to ease the pressure are no indication of the attractiveness of that ill-begotten currency but indications that the Pound is grossly overvalued so competitive production here is becoming impossible. The fact that we couldn’t possibly join the Euro at this exchange rate or anything like it is ignored in this wishful thinking. It is, nevertheless, important that you hear the pain and understand what is really being said, rather than ignoring all these pleas as part of a Euro debate which is irrelevant.
The proof of this particular pudding will be in the eating. Our earlier warnings of recession and high unemployment have not yet materialised because the economy has been boosted by more low paid jobs, higher government spending, a credit explosion and higher stock market and house prices, all stimulating consumer spending if not the real economy. The consequences of overvaluation took some time to emerge in similar situations in the past for the economy creeps on even as the ground crumbles from under, as in 1989. Yet eventually high interest rates and an overvalued Pound hit hard. Ours will, and perhaps suddenly, before the 2001 election approaches, resulting in serious damage to employment, investment, in a further balance of payments deterioration and gloomy prospects for exports, production in the UK and investment.
Conclusion
After two and a half years of Bank independence we can learn lessons. Ours are that you are attempting to deal with a new situation, which you don’t quite understand, by policies relevant to the Seventies and overused since which are both damaging and unnecessary in a low-inflation world.
The Bank projects the consequences of rate changes forward to a time when they can neither be proved nor disproved. It acts with no consistent view on inflation, its course and causes, and little understanding of the effects of interest rates on an exchange rate which is now its prime instrument for fighting inflation. This failure to understand the processes you have embarked on emerges from your minutes, in the inconsistent and diverging opinions which emerge when MPC members speak out, and from your published justifications for decisions. None of these indicate any clear intellectual basis for your strategies, an impression confirmed by your evasions before the Treasury and Civil Service Committees.
Effectively you respond to minor needle flickers on the dials and to uninformed clamour from the financial interest and the pundits who voice its views. This produces destabilising and frequent mini-rate fiddles which always err on the side of caution and deflation, and against growth. It seems to us that you are guided not by any rational understanding but by the instinctive auto-pilot of bankers and other monetarists which is best summed up as "take no risks" "always prefer higher interest rates to lower" "when in doubt deflate". Then you say "Britain is competitive" at any exchange rate - however high - which is really a truism because by definition any industry which survives is competitive but it says nothing about the other industries and jobs which have gone or don’t come because it’s not competitive to produce here. Yet this absurdity is always trotted out as things turn really sour and before capacity is closed and jobs lost because production without profit is ultimately unsustainable. Most press and media opinion provides no intelligent critique of all this, being even more ill-informed and so deeply impregnated with the same simplistic ideology that it actually believes such nonsense as "increase interest rates now to prevent a bigger increase later". Primary school stuff.
Those who are concerned for the strength of an economy able to pay the nation’s way in the world, return us to full employment, and generate the growth needed to provide the betterment people voted for at the last election, know different. A historic opportunity to grow without serious inflationary consequences is being thrown away; performance is pathetic; and we are heading for a substantial and wholly unnecessary cooling just as the Labour government needs buoyancy and growth in the approach to the election. Indeed, the situation is very reminiscent of the optimism, the buoyancy and the follies of the late Eighties, just before it all went sour. The inflation rate is different but the same worrying prospect is again due to the overvaluation of the exchange rate which the Bank has so long sustained with its high real interest rates policy.
Sense may be dawning. We see from your minutes that exchange rate intervention has been considered only to be rejected. It shouldn’t be. One of the policy failures of the last three decades is that intervention is used to stop the Pound going down, and usually when it needs to, but rarely, if ever, to stop it going up. Yet it is much easier to stop rises than falls and intervention is now necessary to do exactly that. So we are enclosing a proposal developed Gerry Holtham, formerly Director of the Institute for Public Policy Research, now Economist for the Norwich Union. It would allow us to get the Pound down by purchasing Euros and European debt, a proposal helpful to the ECB which professes to want the Euro up. This produces a return to the taxpayer in the shape of the higher interest on European debt plus a profit to the reserves from the appreciation of the Euro and the eventual fall in the Pound. We commend this scheme and hope that the committee will consider it.
You will not escape blame for the difficulties that lie ahead. So in your interests, and Britain’s, our advice, so regularly, generously and helpfully given, must now change. You should reduce interest rates by three percentage points, invest heavily in Euro debt, sell Sterling and announce your intention of getting the exchange rate down to a competitive level and keeping it there long term to encourage growth and investment. |
