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Dear Eddie
We have been making regular representations to the Monetary Policy Committee for well over a year and with some success. After a period of ignoring our views, even perversely doing the opposite on occasions, as the deflationary scenario we predicted began to eventuate, you started belatedly to accept our arguments, even though interest rates have not been reduced as soon and as far and fast as they should have been.
You will, we know, reduce them further always too little and too late, but better than never and much better than your first instincts.
This turning point comes at the same time as a widespread realisation that your initial approach was wrong. Both justify, indeed require, a reassessment of the intellectual basis on which you have been acting. Most of your motivating beliefs though common to the financial community and to monetarists are, in our view, wrong. We should, therefore, explain why and set out the alternative approach you now need to adopt.
The catalogue of errors includes the following orthodoxies espoused by the Finance Committee and the Financial Interest.
(1) High interest rates reduce inflation. They certainly damage the economy but with inflation the reverse is true. Higher interest rates increase every cost, impact on the RPI and the headline rate of inflation, thus encouraging wage demands, and setting higher goals in negotiations. The mass of the population face increased costs and higher mortgage repayments. Our inflation has been constantly higher than European rates because our interest rates are higher and, in practice, have been so for a very long period because Finance is so lopsidedly powerful in our economy. Why should our economy be assumed to be able to bear higher interest rates than competitors and can we even get our inflation rate down to German levels if our interest rates remain so much higher? These questions deserve answers as does the view that higher interest rates focus attention on the short term and sustains that aversion to long termism which characterises Britain.
(2) That there is a non-accelerating inflation rate of unemployment. Thus the belief is that if unemployment falls below the NAIRU (or NIARU as some put it) inflation will accelerate. That misguided belief in turn justifies interest rate increases to keep unemployment up to the NAIRU. Yet NAIRU is nonsense as American experience demonstrates. There the NAIRU was assumed by the Fed and others to be between 5.8 to 6.5%. The actual unemployment rate has been below 6% for four years, below 5% for over twelve months. Inflation has decelerated.
Either NAIRU doesn’t exist or it is substantially lower than assumed in the U.S.A. The same is true of this country. Falls in unemployment benefit the excluded and the less well off, so only a substantial fall in unemployment will allow the government’s emphasis on work to operate effectively. The lower the level of unemployment the lower costs and spending. The standard US estimate is that a one percent fall in unemployment is associated with a 2% increase in GDP and the additional growth that generates means lower government borrowing and lower spending on benefits. The Committee might initiate research to define the correlation here and to estimate the financial and social benefits. Such elementary knowledge is crucial to their work and should be made available to the public.
(3) Lower public deficits lead to lower interest rates. These in turn are supposed to lead to more investment. Yet deficits have fallen, real interest rates remain higher than they were and investment has not increased. The gap in demand caused by deficit reduction appears to have been absorbed by consumption, producing pressure on the Bank for higher interest rates to damp demand. We are becoming a consumption not a production economy and as we do so the emphasis is on higher interest rates to manage demand whatever the damage on the production side.
(4) Falling inflation will produce more investment and thus stimulate economic growth. Indeed, it is often argued that it is a necessary prelude to growth. Inflation has come down. Yet so has growth. The assumption is wrong without other measures to manage the economy.
(5) A "natural" rate of inflation. This can only be intended to give the prevailing rates spurious credibility, as if inevitable. In fact, the idea is nonsense. There is only the rate appropriate to the economic strategies government, or the Bank, wants. The Bank of England, like most of the financial community, prefers the certainties of deflation to the risks of growth. So the rate of interest it has set has been "natural" to that end but not any other. Certainly not growth which is in the interests of consumers, producers, the excluded, the unemployed and the great majority of our community.
(6) A decline in the exchange rate has inflationary consequences. This it is then claimed should be compensated by increases in interest rate to prop up the exchange rate. A variation of this is the assumption that inflation can be reduced by overvaluation making imports cheaper. This, too, is a myth. Both doctrines lead to the destruction of domestic productive capacity, increased costs and the cost burden of surplus capacity and higher unemployment on the economy. To reverse this is to reduce costs, to bring down unit costs by increasing production and to ease the burden of interest rates. Past experience indicates that devaluation does not produce a surge in inflation but does make everyone better off by increasing employment and production. The experience of Britain since the ERM debacle and the US since the Dollar came down from its 1985 high bears this out.
If the principles underlying Treasury thinking and the MPC’s approach have only a tenuous relationship to reality and are, indeed, largely wrong, what is the alternative? The basic aim of economic policy must be to boost economic growth. Increasing production brings down unit costs, utilises capital efficiently and increases productivity, in contrast with the obsession with inflation which leads to constantly checking growth. Increasing costs and imposing heavy burdens on the economy as well as increases in government spending are making us ever more dependent on imports, increase trade deficits and the cost of borrowing to finance them. So by damaging manufacturing which is the sector best able to increase productivity and boost growth it moves us further to the stagnant low growth-no growth economy which lives on imports and is dominated by services, themselves more interest rate immune because they do not face the same intense international competition or sell on international markets.
This emphasis requires a change in approach to the exchange rate. Rather than keeping it high to combat inflation by cheaper imports, it must be kept competitive to boost production. This is particularly important in the situation Britain is now faced with by the creation of the Euro. We were overvalued against EU currencies with the result that imports from the EU have increased, exports there have fallen, and the trade deficit with the EU, always substantial, has not only grown much worse but is no longer financed by a surplus with the rest of the World. We are in deficit there, too.
It might have been hoped that the creation of the Euro as a reserve currency which other nations buy to put in their reserves, and the establishment by the Eurobank of a strong deflationary line to create a hard currency would ease this problem. In fact, the Euro has fallen against Sterling. An interest rate gap will remain, however many mini reductions the Bank embarks on over the next year. This will compound the problem, particularly since there is every possibility that the next move in Europe will be down because governments understand that 3% interest rate is too high and they are anxious to get growth and bring down unemployment which is now viewed, and particularly by the Keynesian governments now in power in most European states, as a far more serious problem than inflation.
British policy must, therefore, be to make and keep Sterling competitive against the Euro so as to make production (and investment) in this country profitable. This is difficult for an M.P.C. system preoccupied with inflation. You are now, like a financial Maginot Line, guns trained unerringly in the wrong direction, and on the wrong problem. The Bank and the M.P.C. are obsessed with inflation but the real problem is lack of competitiveness. However, given the importance of growth and its contribution to defeating inflation the two policies are not incompatible, particularly in the light of the further fact that if the Bank doesn’t manage macro policy no-one else will because government is not inclined to do so.
As long as our interest rates remain higher than Europe’s in a single market our costs will be higher, our wages pressure worse, our exchange rate and hence the price of our exports higher, and that of imports lower, and the more we will have to pay out in subsidy to firms to either establish themselves or stay in a country from which they find greater difficulties in producing and exporting, and in which they cannot produce as profitably as elsewhere. The more we prolong that situation the worse the economy gets and the worse the problem of "deflationary inflation" which has haunted the British economy for so long.
We must now endure an unnecessary recession and a fall in growth which the Bank has caused by its misguided interest rate policy but this is the time to reverse policy more massively to prepare the way out of a recession which is inevitable however much you, Treasury and the pundits quibble about its scale. Now is the time to recognise that we have to produce our way out of the inflationary trap by making growth central and going for it. This requires you to indicate to business that policy has changed from using deflation as a discipline to getting growth as the best way of reducing inflation. You must assure business that this will be a long term strategy and that the prospects for investment and production in this country will be improved to keep Britain competitive so as to underpin a sustained expansion and the long term prospect of profitability which will alone ensure investment. The future is in your hands. This is a more substantial role than the tinkering and fine tuning you may have envisaged initially. It requires a very different and much more rational approach to the one you have embarked on for the first sixteen months of your life.
Finally, a further point which could become crucial. Government is committed (wrongly in our view) to membership of "a successful Euro"; "when the time is ripe". Practical politics imply a three year time scale to a referendum after the next election. Assuming, as the government is, that this ungainly monster can be made to work without redistributive spending and that the people can be conned into voting for it (though we agree with neither assumption) then government is going to have to start preparing for membership. Preparations must centre on two problems. First convergence by building up the competitive strength of our economy and our productive sector so they won’t be clobbered in an open market when exposed to the full blast of competition from bigger better invested and more productive industries in, for instance, Germany. At present we are doing the opposite and that will go on for a year.
Second membership implies a docking point, a target rate for Sterling vis a vis the Euro at which we can go in and be competitive. Views will differ on this. Our preferred rate would be very low. Others, particularly the Financial interest, will want it high. British industry in its vacuous way will urge something in between. No-one in their right minds would want to go in at this rate or anything near it and even the Liberals aren’t quite saying that. It would be useful if the Bank or government calculated and published a Euro exchange rate backwards to, say, 1992 so that people can see what is happening and we can avoid misinformation about the Pound "coming down" when it isn’t in any substantial way. Yet the fact that the Euro itself has gone down from 71p to 69p against Sterling since its launch, while our exchange rate against the DMark is still within the ERM bands which did so much damage only seven years ago both indicate that overvaluation is still substantial. All the job losses in manufacturing, the gloom in the C.B.I., the transfers of production to Europe and the demands from car manufacturers for subsidies to stay, indicate the central truth which we have continuously emphasised: it is just not profitable to produce in this country at this exchange rate. Those firms which survive will say they are competitive. Indeed, some will go down still saying it. Yet that is no more than a truism and takes no account of the investment that doesn’t come, the firms and production we have closed, and the new business we need to attract.
So we can only enter the Euro at a lower exchange rate. Yet how are we to get it and maintain it for the sustained period, probably two years, which will be considered necessary? We can’t suddenly reduce interest rates and let Sterling fall a few weeks or even months before we go in. So we must start thinking now about a rate of entry and how we manage interest rates to get there. Nor can we assume that a government which has shown an obstinate aversion to having any macro policy at all will do it. Indeed, the Chancellor is only beginning now to use the fiscal weapon to boost demand for the next three years, and then not enough in the light of the rapid deceleration we are now experiencing.
Responsibility for management of Sterling vis a vis the Euro, therefore, falls to the Bank making it essential that our interest rates be reduced to a level below those for the Euro. We need this to maintain a competitive edge, to boost investment in this country, to indicate that we are to be made and kept a profitable centre for production, and to establishthe only exchange rate for Sterling which can be viewed as "natural".
Thus long term prospects and the processes of Euro management both point in the same direction: to the strategy on which we have concentrated the bulk of our advice. That means immediate reduction of 2% in interest rates, as a prelude to the further reduction necessary to take us below a Euro rate which may come down soon. We would not want the Bank of England to lamely tag along behind Europe because this would maintain the impression that British rates will always be higher than those in Euroland and our reductions slower and more grudging and are competitive base inadequate because here Finance rules. |
