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23 January 2008
Mervyn King Esq
Governor
Bank of England
Threadneedle Street
London EC2R 8AH
Dear Mervyn
The Bank should reduce interest rates by one half of one percent this month. That should be as part of a progressive programme of rate reduction to bring British rates to American levels, or preferably below, over the first months of 2008. That programme should be announced now to give a certainty to markets which the Bank`s usual policy of fidgeting rates up and down can`t.
that interest rates must come down. If the Bank`s chosen way of doing this is marginal shift by marginal shift rather than the bolder American approach then the process of reduction has to be steady and maintained month by month to create a clear understanding in markets, where assessments of both the economic situation and the necessary action are all over the place. A large reduction now could be viewed as creating while avoiding the anxieties and fears that the Bank knows something markets don`t or that the situation is worse than is realised. Big reductions are so unusual in this country, though not in the US where there is a much clearer understanding of how serious the situation is and money markets have a greater influence over Fed policy. So there are arguments for little by little but to work cuts must be sustained and proclaimed as part of a programme.
The Governor has done a disservice by his recent speech indicating that the Bank wants to “tough it out”. Trite moralism is no basis for the management of a faltering economy and a panicky Financial Sector. That situation requires sense and a flexible response to real problems, not endless moralising of the type which served us so badly in July-August and will do so again now.
In good times and low inflation the Bank saw fit to use an overvalued pound, kept too high by ever higher interest rates, as its prime weapon against inflation. It kept import prices low and enforced a discipline on industry to keep costs and wages down. That weapon was used at a heavy cost because it also destroyed well over a million jobs in manufacturing and wasted Britain`s opportunity to grow at the higher rate necessary to repair the damage done in the eighties and bring standards and services up to those of an advanced economy.
Now that policy has reached its nemesis and the inevitable price has to be paid. Its results are a huge balance of trade deficit, and market pressure bringing the pound down. If the Bank now tries to sustain its failed policy by using higher interest rates (or keeping them too high)
to check the pound`s fall and creating alarms that `devaluation` (which this isn`t, devaluation being a deliberate act where this is a market inevitability) the consequences will be disastrous:
(a) It will compound the problem, make the damage to production, which is already unprofitable, worse and lock UK into recession.
(b) It will prevent any sensible response to the fall in the pound by using it as part of a programme to boost demand and profits.
(c) It will turn the Bank into a mechanical Doomsday Machine.
(d) It will be based on wrong assumptions, viz that a fall in the pound is inevitably inflationary. Look at the devaluations of 1949, 1967, 1972 and 1992. All boosted production with no substantial increase in inflation. We have explained throughout that an increase in production is the only sure way to defeat inflation. There is, therefore, no way the Bank can claim to be keeping rates high to defeat anticipated inflation in the way it usually does. The Bank can`t foresee the future and economic management is not a kind of séance so there is no reason for anticipating now a rise in inflation which is a banker`s bogeyman not an inevitability.
The Governor is correct in saying that inflationary pressures are strong but that is because of the increase in fuel, food and utility prices. The Bank can do nothing at all about any of this and high interest rates merely compound the problem. Indeed the only way the Bank could show that high rates reduce inflation is if it assumes that the increased prices for fuel and utilities result in unsustainable wages pressure. They don`t. So what is the point in sado-masochism as an economic policy? It`s just a reversion to the failed policies of the sixties.
All this indicates that the Bank has to behave more like the Fed and take the wider interests of the economy into account. With the inflation rubric being both unique and tighter here this demands both guile and sense of realities. However, the inflation measure has been changed to give more leeway for both. Indeed under the Bank`s measure it is only marginally (0.1%) over target which actually gives leeway for a reduction. Present high levels of inflation can be treated as temporary highs, certain to come down. Wages pressure is low. In any case when, and if, the Bank writes to the Chancellor to explain its failure there is a powerful logic to the argument that it can`t do anything at all about the present causes of inflation. It can argue that it is reducing rates to avoid recession and prevent inflation getting worse. If the economy stalls inflation will result from higher unemployment and distress, needing more public spending, unused or underused resources, productivity falling with production and a threat to the stability of banks and the financial sector, from bankruptcies, house repossessions which can`t be sold on a falling market, excessive debt which can`t be sustained on falling house prices, and daft levels of sub prime lending in the UK.
This effectively shifts the issue back to government. Government has the prime responsibility to act, as the US is, by supporting threatened home owners, by cutting taxes on the less well off and by stimulating demand. There is no sign that it is doing so but that makes it even more important for the Bank to do what it can.
Britain is more exposed to the threat of recession than most other countries. European leaders, particularly in Germany, may be right in saying “the fundamentals are sound”. Ours aren`t. We have not rebuilt our productive base as Germany has. We have gambled away the good years. We have allowed an excess burden of debt to accumulate. We have allowed house and asset price to inflate to daft levels. We have given too much power to a financial sector which always heightens risks to make profit. We have put ourselves in the power of the money lenders. If in that situation the Bank behaves like a demented Dalek on autopilot, prating on about moral hazard and toughing out a problem it itself has created, it will fail the country without achieving its 2% target.
You will receive lots of detailed arguments, figures on inflation, labour markets, bond rates and liquidity from others so we don`t intend to bother with all that. Our argument is that it`s time the Bank averted its eyes from the details to the big picture (as our late Prime Minister put it), stopped exuding false confidence and got to grips with the real issues as the Fed has. The government won`t. The Bank has to. Follow the Fed. Their record is better.
Yours sincerely
AUSTIN MITCHELL JOHN MILLS
Chair, Labour Economic Secretary, Labour Economic
Policy Group Policy Group
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