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Dear Mervyn King
Last month`s surprising and, we feel, misguided decision to increase interest rates once again and move even further out of line with the central banks of the other major economies was a mistake. It`s the more worrying because of what it reveals about the thinking behind Bank strategy. Our recommendation this month is that you should resile from it, take two percentage points off interest rates and bring them into line with the other major economies, hopefully to an intermediate point between the FED and the ECB.
The exchange rate should now be the dominant consideration. It is and has long been far too high for competitiveness. The rise in interest rates gives the signal to markets that the Bank wants it to stay high because its chosen way of fighting inflation is by keeping the costs of imports low and forcing British producers to cut costs and employment in a desperate, and unsuccessful, attempt to maintain competitiveness.
In Euroland by contrast there is more understanding of the role of the exchange rate and a clear recognition that the euro is too high. This has a depressing effect on the economy, particularly in Germany, whose Chancellor is openly urging the reduction of interest rates as the best way of bringing the euro down and restoring lost competitiveness. It is extraordinary that the same concerns are not being voiced in Britain where the damage done by a grossly overvalued exchange rate which has been too high for too long, has ensured that production in the UK is unprofitable, manufacturing has shrunk massively and is still shrinking and the trend to shift jobs and production overseas or to rely on imports and imported components has become overwhelming.
By its high interest rate policies the Bank is compounding this trend and all the problems it gives rise to. Overvaluation is a finite state which leads only to economic crisis and a collapse in the rate. Maintaining it by high interest rates takes no account of the consequences, the loss of employment, the effect on investment in this country and the gaping balance of payments, indeed the long term survival of a competitive
economy which can no longer pay its way in the world and can only finance the flow of imports by ever more borrowing. Overvaluation puts Britain in hock to the future while at the same time destroying its ability to survive and pay its way in the world. This is irresponsible short termism. The Bank should consider why no other country is prepared to damage its productive industrial base in this way and revise its views on the connection between interest rates and the exchange rate.
The situation is more worrying because the Bank has not been able to produce any valid reasons in terms of an inflationary threat, unique to this country, to justify either the last two rises or keeping our rates so much higher than everyone else`s. The inflation rate is well below target. That gives a margin to reduce rates and expand the economy which should be seized. There is pressure from house prices but that is not the responsibility of the Bank and does not feature in its new inflation target. It is, in any case, hardly realistic to argue that higher interest rates are the best or only way of dealing with house prices or of choking off the credit explosion which, along with higher public sending, keeps the economy growing by providing the credit for people to buy the imports. House prices and credit control are governmental responsibilities not that of a Bank of England charged with achieving a defined inflation target, which it has always overshot.
We will not go over the arguments we have put forward in previous months. We must, however, emphasise that both the Bank and the government are working on assumptions which will prove to be over-optimistic. Against the dollar we are now as overvalued as when we left the ERM. At this exchange rate or anything like it there is no other prospect but low growth, rising imports, failing exports, and a continued decline in the productive sector of the economy leading to a rise in unemployment.
The British exchange rate should come down with the dollar, which the market forces generated by the US`s gaping trade deficit will continue to push down. The euro should go still higher as money flows out of the US into Europe. In that situation it will be deeply damaging for the pound to rise with the euro. That cuts ourselves off from American markets and yet fails to make us competitive in a stagnant Europe where the competition is deeply entrenched. The prospect this points to is low growth and higher unemployment. Government plans to increase public spending all depend on higher growth because only that can obviate the need to raise taxes but we won`t get it. Thus if the Bank of England continues its policies of keeping the pound high to fight an inflation which does not really threaten, it will make Britain the declining section of an improving world.
The Monetary Policy Committee should ask itself why British interest rates have to be so high compared with those of the ECB and the Fed, and what the consequences of this differential are on our exchange rate and on the level of economic activity and the long term prospects of the British economy. As the signs of recession emerge, house prices will fall and we will be back in the miseries of negative equity coupled with an inability to finance the huge credit burdens. The Americans are at least opting for the sensible escape route and if we don`t join them now we will be forced to by a fall in sterling later on. Wait and see is not an option for an economy which cannot pay its way. |
