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Dear Sir Eddie
You will have noticed, I know with real regret, that our advice has been lacking for some time. As a result policy has gone a little astray, principally with the decision to raise interest rates. This sent out a series of wrong signals and was construed as a sign that rates are on their way back up. It is time, therefore, to resume our monthly letter of advice to avoid this happening again.
We have two basic reasons for doing so. A longer perspective now gives time for a review of how the Monetary Policy works and where it is going wrong. More importantly this is the end of the golden weather and the beginning of a time of greater economic difficulties. We are going into this backwards, obsessed with the lessons of the nineteen eighties, at a time when the problems are, in fact, different so the policy measures necessary to deal with them need to be very different again.
We feel that the Bank has erred consistently and for too long in the devotion of excessive caution. This has kept the Pound far too high so the great opportunity we now have to go for growth and repair the damage done in two decades of excessive and unnecessary deflation is being lost.
The change is produced by the decline in the threat of inflation. We have pointed out consistently that the power of Labour and the unions is largely broken, that capital and manufacturers can`t control their prices, that competition is now intense. Huge new production capacities are now coming on stream, all capable of producing high quality goods at ever lower prices. That will bring prices down long term. In addition better distribution, competition to serve the consumer, and "just in time" production have all helped to hold down prices. The old ability to manage prices has been lost by both producers and labour so inflation in one country is not now going to happen. Yet you have consistently exaggerated the threat. The Bank`s estimates of inflation to come have been regularly too high. Its inflation target has been consistently undershot, meaning you have slack you could have used to bring interest rates down more, and
allow the economy to grow more than you have. Kenneth Wallis`s research is relevant here, particularly bearing in mind that if you had erred to the same degree the other way then the potential expansion allowed would have been even more substantial.
It seems to us that the Bank has consistently underestimated the ability of the British economy to grow without inflationary consequences. It is almost as if the reforms of the eighties and nineties had never been. Yet all were calculated, you will remember, to shed fat, surplus labour, cut costs, trim the economy down to the bone, all to allow it to seize opportunity and grow. Now however, it's being held back from doing so by lack of faith that growth can now happen pretty well without substantial inflationary consequences. Thus by keeping interest rates high in real terms and higher than those in competitor countries, specifically Europe, the US and Japan, you have imposed additional costs on our economy and kept the Pound higher than it would otherwise be, thus making imports cheap and compelling British manufacturers to cut costs to meet this competition.
Intended or not, that was the effect and it gives the Bank a vested interest in keeping the Pound at an overvalued level. It also indicates that if it comes down there is a danger of being panicked into fighting the market. That would be disastrous (as Mrs Thatcher pointed out, you can`t buck the market). By raising interest rates to combat a feared increase in inflation from the falling Pound you would be compounding the damage and shoring up the exchange rate which has caused it in the first place. The fear is, in any case, unrealistic. A fall in the exchange rate would generate expansion, bring surplus capacity into use, and reduce costs per unit and generate more jobs thus easing the problem of tax inflation. The doves on the MPC have been consistently right, the hawks consistently wrong. The Bank should now consider assessing what interest rates would have been had its position not been so restrictive and what effect this would have had on the Pound and economic growth.
The prospects for the economy are worrying. We have consistently drawn attention to the damaging effects of a Pound which is substantially overvalued. In our view it is more than 30% overvalued against a basket, more against the Euro and recent leaks indicate that Treasury too regards it as overvalued. The effects of this can, and have been, concealed for some time by the increases in government spending which have mercifully been introduced by this government, and by the consumer boom generated by lower interest rates and a credit expansion. Yet long term these are superficial phenomena, improving the statistics, but doing nothing about the basic problem.
The consequences of overvaluation are inevitable and remorseless. Each time we get into such a situation reassuring voices tell us that manufacturing can "live" with the exchange rate, that it doesn`t matter any more, that it makes raw materials cheaper and that all that's necessary is to cut costs and become more efficient (a process which has supposedly been going on for twenty years now) and all will be well. Each time the decline goes on behind a smokescreen of waffle. They have been going on for a long time now under this prolonged overvaluation. Its consequences have been less severe this time than in the early eighties and the early nineties, concealed by the
fact that those who survived the two big doses of deflation were fitter, leaner, and better able to survive another dose. For a period.
That period is coming to an end. We have already lost over half a million jobs from the manufacturing sector. Production is contracting, capacity closing. It is just not profitable to produce in this country at this exchange rate or anything like it. Look at the profits of the Japanese car plants. Exports are falling, imports rising substantially, to supply the consumer demand which cheap credit and equity withdrawal have fuelled. The balance of trade gapes ever wider meaning that we are being kept going by borrowing and by selling more and more British assets, albeit to unsuspecting innocents. All these are finite processes which should now be your central focus of your attention.
The slowing of growth in recent months to a level well below Treasury projections (which are themselves suspect) is not a temporary phenomenon but indicates the end of the golden weather which has kept us sailing on until now when the chickens come home to roost. From September to date your central preoccupation had to be what could be done to prevent economic collapse here and in the world economy to which our propensity to import is making such a major contribution. Other central banks, from the US which gave the lead, to the ECB and Australia and New Zealand, all rightly followed suit, though you still maintained a margin of higher rates which was unnecessary.
Now that purpose has been achieved. America will pick up, Europe too because the weak Euro must be an economic stimulus. We won`t. America will be able to go on importing with the overvalued dollar and their willingness to run a gaping deficit. European economies will pick up. We won`t be able to seize the advantages arising from either development because we have shackled ourselves with overvaluation. Far from being able to pride ourselves at leading the world we will become the laggard nation falling behind, limping pathetically and living on credit, both at home and abroad.
To speculate beyond that is difficult. Market forces should bring the dollar down and sterling with it. If that happens the euro will go up as capital flows find a home there and grab the appreciation, though of course there will be damage to exports longer term. We can however leave this kind of speculation to the speculators and the pundits. The immediate problem is to revive a flagging British economy. That requires a substantial cut in interest rates. We are aware that seeing yourself as having done your duty to the world economy, albeit grudgingly, you will now want to temporise with another wait and see holding period at present rates. That is just not good enough when present rates are far too high and having a damaging effect on the economy. The world will recover and at this exchange rate we can`t recover with it. So the need now is to act for Britain and particularly to get down an exchange rate which has been far too high for far too long. Reducing interests rates is the only way to do what markets will eventually do for us as our prospect deteriorates, as the balance of trade gapes and the world becomes more reluctant to lend us more to
finance what is becoming a wastrel's progress of endless consumption and declining production.
Which is why you should get in first by giving a signal to the markets that British rates are not going back up, whatever the rest of the world may do. It's the signal which is important not the immediate effect on the exchange rate, though we would suggest that the rate reduction should be accompanied by a concerted effort to talk the pound down by going on about moving the pendulum back to manufacturing, giving exports and production a chance etc, plus all the things you've been dying to say after your regular expressions of sympathy for manufacturing.
Beyond this we have already suggested market transactions and, specifically, borrowing and investing a few score billion in French or German public debt announcing that it is a sign of our confidence in the Euro while knowing that it will help that benighted currency up and the Pound down. With all this going on markets will get the message and we will have the managed devaluation we need. Don't be afraid of a sudden, cataclysmic fall, it isn`t going to happen, merely a necessary adjustment which you will encourage.
Begin now and you control the situation. Delay or, worse still, put rates up again as some still expect you to, and the deterioration will be rapid and uncontrollable. Firms which have struggled on will give up because they can see no hope of a sensible exchange rate. Low growth will make it clear that the Chancellor is going to have to borrow substantially, and the EU will amplify its noises about this. So confidence will sink and money will begin to leave because no one can see a prospect of profit.
No nation can damage its production, run a balance of trade deficit, borrow to finance it and consume imports on credit forever and the Bank will, we hope, discourage this. We are missing out on the best opportunity to make up the backlog of slow growth we have long suffered from because of high real interest rates and the overvalued Pound they support. |
