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Dear Eddie
Interest rates in this country are too high in both real and comparative terms and the exchange rate has long been far too high. So our recommendation this month, consistent with all our earlier representations, must be that you reduce interest rates by 2% and that you aim to bring British rates into line with Europe’s since there is no conceivable reason why ours should be double theirs.
This will move the economic signals to expansion, growth and the reduction of unemployment. All are now possible in an age of low inflation. They cannot, however, be achieved unless you allow the exchange rate to return to a more realistic level vis a vis the European currencies and usher in a period of sustained low interest rates.
A substantial reduction is necessary to give the clear signal the economy needs. You should set a rate which can be sustained for a long period. Firms, producers and investors all need to be confident that they can invest with a degree of certainty. In the past all the many firms who listened to government encouragement to invest, expand and grow were promptly penalised by the subsequent increase in interest rates in the subsequent deflation. Those who had expanded most were most at risk. Our Labour Government is committed to avoiding this in future by eliminating the excesses of Stop Go. We have hardly achieved a "Go" yet. Indeed, the process of economic management since 1997 has been to slow the growth we inherited. As that flags so the need for a boost increases in order that the confidence which was developing, but has been damped by lower expectations over the past year, can be sustained. We can only do that by boosting growth onto a sustained basis.
We feel that the British economy now has a rare opportunity to expand which it would be irresponsible not to seize. In the past expansion has always been checked by balance of payments problems and, more particularly since the Pound floated, fears of inflation. We now have the opportunity to grow. The exchange rate can float down through balance of payments problems and the impact of oil on the balance of payments makes that problem easier. It will increase if the oil price rises. This is a confidence builder, albeit minor. More important inflation is not really a problem. Expansion can now take place without boosting it to any level likely to be dangerous. We feel that your actions, your predictive models and your conditioned attitudes have not changed enough and that you do recognise that low inflation is here to stay creating a new and very different set of priorities. Just to enumerate some of the factors they are :-
- Excessive productive capacity and intense competition in manufacturing and increasingly in services all keeping prices low.
- Competitor devaluations keeping the price of imports low and holding down domestic prices which compete with them.
- More efficient markets and the increasing power and competition of supermarkets and growing transparency.
- The breaking of Labour power, aspects of which are the weakening of the power of the trade unions and the ending of Labour monopolies in the docks, transport and elsewhere, the increase in the number of small firms and self employment, not to forget high unemployment.
- Increasingly intense competition at home and abroad. This means that very few now even dare to consider raising prices; many more are keeping going without profit to stay in business and hold market share.
- The increasing shift in production from Britain to countries with lower Labour costs. Look what is happening to Marks & Spencer and what BMW is forcing its suppliers to do. These are the visible and outward signs of a process which has gone on for years and is now becoming intense affecting everything from Doc Martens to cloth finishing.
* The breaking of pricing power, partly a regulatory fact, mainly a result of markets. Who now does or has the power to raise prices?
We do not go so far as some who discern to a coming age of deflation. Yet we would point out that low inflation is here to stay and that this returns us to what has been the norm for long periods of economic development. If in that situation the British economy cannot afford a rate of growth as high, or preferably higher than it was able to attain in the Fifties and Sixties when none of the other changes listed above applied, and when we are told the economy was riddled with monopolies and restrictions, then two questions arise. What was the point of all the liberalisation reforms of the Eighties and early Nineties? When, if ever, will the British economy be allowed and able to expand?
The MPC is ignoring this new realism. It is too much influenced by attitudes and expectations formed in the period of inflation which developed in the Seventies and Eighties to become obsessive in the financial community which rose to economic dominance in that period. This has played too large a part in your thinking in the following ways:-
- The preoccupation with the concept of "non inflationary levels of unemployment". This has produced a simplistic assumption that inflation must rise as unemployment comes down. This has been demonstrated to be false in both Britain and the United States. The economic reforms listed above ensure that the trade-off does not now work. On simple a priori grounds it is clear that people going off unemployment into low paid jobs (which so many are), working for smaller firms (which again so many are) can hardly act as an inflationary pressure. However, they do increase the tax intake (minimally) and reduce government spending (more substantially).
- The assumption that any increase in economic activity, however financed, is inflationary, so that as soon as consumer demand rises, whether financed by equity withdrawal, loose credit or (in the US) stock market Keynesianism, any increase in house prices, any increase in earnings, must automatically lead to an increase in interest rates to punish the naughtiness. This is more an assumption among simple-minded pundits outside the MPC. Yet we can see little other reason than this for the last mini increase.
- Assumptions about the rate of growth at which the British economy can expand are all far too conservative, because based on the experience of the Seventies and Eighties rather than on a period of low inflation. Look at the experience of the 1930s. Then our growth rate was one of the most rapid in our history - and the world - but inflation remained very low. Indeed, the Bank of England had to co-operate in a policy of deliberately trying to increase prices. The Treasury is considering raising the sustainable growth rate possibly to 3%. The Bank should tell us its view so that this can be discussed and the fallacies underlying both in today’s changed circumstances brought out.
- Assumptions about the effect of any increase in interest rates, the time lag after which those effects begin to operate, and the way in which they make themselves felt. The conventional wisdom, always trotted out on these occasions, is that a stitch in time saves nine. Yet no indication is either given or available of how, why or when. The assumption on which the Bank’s models and thinking are based do need to be closely examined and the desire of members of the MPC to have greater access to these should be accepted so that the necessary debate can go on. Similarly we have consistently argued that the effect of interest rates themselves on inflation merits close examination.
Influenced by these factors the Bank of England and its MPC have paid too little attention to the basic economic realities of an overvaluation which is crippling the real economy of manufacturing and production and shrinking the manufacturing industrial base to levels where it is far too low to sustain employment, or provide the increases in productivity which only manufacturing can generate. We are being transformed into a rentier economy uniquely dependent on imports without any thought of the consequences.
Common-sense indicates that as these processes go on the balance of trade must deteriorate and the deficit widen, eventually producing a crisis of confidence in an exchange rate which will on past precedents then be defended by even higher interest rates. Even if markets don’t operate on the exchange rate we must emphasise that any government which intends to join the Euro will have to get it down over the next three years by 23%, the view of Keith Church in National Institute Economic Review (169), more in ours. So in our view you now have the opportunity to anticipate both developments and to avoid forced consequences by getting interest rates and consequently the exchange rate down now. Then the economy can adjust more naturally and without the inevitable damage which must ensue if these processes come to fruition.
You have in the past accepted a degree of responsibility for macro management and used it in justification of some of the interest rate changes which have taken place. However were you to ignore it completely your present trends would still point to the need for interest rate reduction since on the one solid undeniable criterion you were given, the target of 2.5% inflation, rates should come down since we are now below target and likely, we would say certain, to remain so. That inflation figure provides no justification at all for a rate increase, every argument for a reduction. The reduction should be substantial to indicate that the substantial change in approach which is necessary and to avoid the cost of constant fidgeting of rates. We accept that mini adjustments are the result of committee democracy but agree with the NIESR that "rate fidgeting" is expensive, inefficient and unnecessary. It will be eliminated only by the sustained "cheap money" policy the economy needs.
We hope that you will not discount our arguments on the basis of an old fashioned belief that it is not possible to raise economic growth rates by demand led expansion. Export demand stimulated by low exchange rates has been the formula for the growth of all the countries which have industrialised since the war. It was the starting point for German, French and Italian growth and is now sustaining recovery in Europe. There is no reason in a low inflation world why such an expansion should lead to the old boom bust cycle but every indication that those who do not enjoy them will be left behind.
Nor is the endogenous growth argument that we can only grow if we tackle our own supply side problems first relevant. Supply side problems have to be tackled, bottlenecks broken and skills upgraded but to argue that any of this will take place without an increase in domestic demand and better export prospects to hold out prospects of profit lead to higher levels of investment betrays no knowledge of the real economy. There investment is dependent on the prospect of profit and better business ahead prospects. In the past these have had to be positively glittering to lure British industry into the necessary supply side changes. They certainly cannot arise if the future is one of deflationary caution based on a high interest rate policy.
The Bank is in danger of overplaying its luck. The economy has weathered the problems better than we or anyone else expected. Yet that is no argument for believing that it can continue to do so as manufacturing shrinks, as imports become ever more competitive and exports less and less so, and as the balance of trade gets worse. We cannot compete in European and Eastern markets as they recover, shackled by high interest rates and an exchange rate which has been so overvalued for so long. After a time anorexia kills and processes which are demonstrably finite produce the damage they point towards. We would, therefore, draw your attention once again to the arguments for growth set out in our printed letter to the Monetary Policy Committee and ask why Britain alone should be so uniquely unable to benefit from them? |
