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Dear Mervyn
Conventional financial opinion is convinced that the Monetary Policy Committee will raise interest rates. Again. The further assumption is that it will embark on a series of rises throughout the year. We, of course, advise against such an increase which puts you on a slippery slope to a “normal” rate which doesn`t actually exist. It provides a test of how far you and your Committee share the instinctive prejudices and attitudes of the financial interest but an increase now has no other value. On the contrary, we reiterate our advice that you should reduce interest rates by something more than the grudging mini-percentage point movement to which the MPC has become addicted.
A prime consideration must be international relativities. The ECB`s rate is 2%. It is unlikely to raise it because they realise the dangers of over-exchange rate appreciation. They fear that the euro zone is not competitive and see the effects of overvaluation in Germany, the drive motor of Europe.
Evidence in the US is even clearer and their rates even lower as part of a massive stimulus by tax cuts and cheap money which will be maintained, partly because the growth assumed earlier is not as substantial as was hoped, but mainly because the election isn`t until November. No government and no politically sensitive central bank is going to damp down before that.
As a result the dollar will continue to fall against the euro which won`t rise as far or as fast as it should because of the lack of any central economic management and the uncertainties over the Stability and Growth Pact. The pound which all, including the Bank, agree is substantially overvalued, will stay high. There is real disagreement about the degree of overvaluation and we put it much higher than the MPC and the CBI but recent falls have made all too little difference and it remains higher than it needs to be to maintain British exports to the US or to even hold ground in a European market where competition is intensified.
There is no logic to this overvaluation. Its consequence must be serious for production, exports, tourism, the balance of trade and employment. A reduction in interest rates is the only way to bring down the exchange rate. It gives a signal to markets. If we move interest rates down to American or European levels the signal will be that we are happy for sterling to come down with the dollar as it needs to. In keeping interest rates up, even worse increasing them, you indicate that you are happy to see the pound remain overvalued.
We are concerned that there is a widespread assumption, which the MPC at times appears to share, that a rise in economic activity automatically means a rise in interest rates as though it were the Bank`s duty automatically to damp growth. This is dangerously defeatist about Britain and its economic prospects. It is also economically illogical. Growth generates its own demand and demand its own growth. In our view demand needs boosting. That requires lower interest rates and a more competitive exchange rate.
The assumption behind Finance`s alternative of punishing Britain for growth is that the British economy is incapable of faster growth, despite all the reforms of the eighties and nineties which were supposed to have freed it up and made it more responsive. That would mean it can never again attain the faster rates of growth others have and Britain did in the past. It ignores the fact that in damping consumption and seeking to restrict credit the Bank is constantly harming the production economy. It assumes that capacity is now tightly constrained when all the evidence indicates that it is underused, with the inevitable result of higher unit costs. It assumes that bottlenecks, wage inflation and intolerable strains will all result from a growth rate which is low by past standards.
None of these assumptions is realistic, particularly outside the South East. Sadly, though, they do allow the Bank to increase interest rates in defiance of present facts and present inflation levels which, in fact, would allow a reduction. The Bank usually raises them on the assumption that it is combating inflation at some future date which will arise if its engrained assumptions are believed. This is mysticism but such Old Lady fears rule out any prospect of Britain going for the higher growth it now needs to bring down inflation by reducing interest rates, breaking bottlenecks, bringing new capacity on stream, restoring faith in the productive economy and allowing the economy to bear the increases in public spending planned for it without the tax increases which are so widely feared.
Without a boost to a higher growth path now Britain is locked into a trap of high unit costs, uncompetitive cost levels, low productivity increases (because that increases with production) and a deteriorating balance of trade as oil`s contribution to the trade balance declines.
As all that happens, faith in a declining economy will be lost, markets will bring the pound down, and a historic chance of expanding through the problems will have been thrown away by a Bank of England which will then opt for higher interest rates because of its innocent assumption that a fall in the exchange rate is inflationary. In our view we are at this turning point. So an increase in interest rates now would have
more serious consequences than the MPC might assume, even apart from its depressing effects on consumers and the return of the negative equity trap in a nation which has become accustomed to higher levels of credit and debt.
On the other hand, an increase in interest rates now will ensure that Britain makes a bigger contribution to the world-wide effort to restart the world economy. It would boost a recovery here which, however much pride we take in, it is far too weak and is unlikely to be sustained because it isn`t based on any expansion of production or any boost to exports. It will make it more attractive to invest in this country and to produce profitably.
We see no reasons which could justify an increase in interest rates now, however small. We see several reasons why it will be damaging in a heavily borrowed community, and more still why interest rates should be reduced to help us sustain our position in American markets and compete in a European market where the overvaluation of the euro gives us better prospects, but only if we are more competitive.
We suggest that the Bank needs to think outside its tightly circumscribed box with its inaccurate assumptions about the real economy and its excessive deference to the interests and demands of the financial economy. The Bank should focus now on the real economy of manufacturing, production, and export competitiveness, all of which have been so badly damaged by unnecessarily high interest rates and excessively high exchange rates. Sustained and substantial growth is needed to justify major investment and allow the economy to maintain the higher levels of public spending and the improvements in public services we need. It is also the only long term way of defeating inflation. We urge you to think growth rather than micro fiddling. |
