The demands for an interest rate cut are growing. Financial markets are "seizing up" again, credit lines are closing down, and asset prices, particularly housing, are beginning to slide. Banks, newspapers, homeowners, and speculators are now looking to the Bank of England for a helping hand. "If only interest rates could come down 0.25 percent", so the pleading goes "everything would be resolved". Banks would begin lending to each other, house prices would stop falling, and a recession would be avoided.
If only it were that easy. Sit back and ask the following question - how did we get into this mess? It all started about five years ago when the Bank of England started to print more money than it should have. This easy money found its way into the housing market, and prompted an unsustainable rise in property prices.
The Bank of England were not alone. Other central banks, most notably the Federal Reserve in America, were at the same game. In Spain, Ireland, Eastern Europe, and Australia, house prices were rising at an unsustainable rate due to an unprecedented relaxation of lending standard and an environment of historically low interest rates. In the frenzy that followed, banks extended loans to people who had no real prospect of repaying.
The bubble wasn't just contained within the property market. Easy credit and low interest rates encouraged people to consume more and save less. Rising consumption may have kept the economy growing, but at the expense of ever rising levels of personal debt.
Of course, this could not go on forever. At some point, the banks began to realise that a large proportion of their customers did not have the income to sustain the growing levels of personal indebtedness. Everyone knows that there are piles of worthless credit agreements sitting on the balance sheets of the banking sector. Now, banks are scrambling for cash, to ensure that they don't follow the sorry path that Northern Rock took the summer. At least for the present, cash is king and no sensible bank will risk lending to bail out any other cash-strapped competitor.
Here in lies the problem. An interest-rate cut won't help much if many the customers are ready effectively bankrupt and cannot repay you. At the margin, it might prevent one or two of your more sensible clients from defaulting. However, the relief will be limited and temporary. Furthermore, there is a selection problem that interest-rate cut won't help resolve. Any bank looking for short-term loan runs the risk of admitting that it has serious funding problems. Any bank asking for credit right now is almost certainly a bank that other banks should avoid.
What would happen if the Bank of England succumbed to all this pressure and cut rates? Households would probably go on another credit card driven spend fest over Christmas. Perhaps house prices might stabilise for a few months. Higher demand for consumer goods would probably keep inflation boiling over. However, by February or March, all the underlying problems would remain. Inflation would be red hot and rising, personal sector indebtedness would be higher, and house prices would still need to come down. Perhaps more importantly, banking sector balance sheets would still be in poor shape.
Here, the United States provides a telling example. During the summer, the credit crunch reduced interbank lending. Short-term interest rates increased suddenly, and many banks and financial institutions were scrambling for cash.
In a moment of panic and desperation, the Federal reserve cut interest rates by 0.5 percent. For a time, the liquidity crisis subsided. However, nothing fundamentally changed. The banks were still carrying large amounts of bad debts. After the euphoria of the interest-rate cut, doubts began to creep back in. The credit crunch returned. Short-term interest rates again are rising, and the Federal reserve are threatening a further interest rate cut.
The lesson from the US is clear. Lower interest rates can only provide an illusion that the credit crunch has been resolved. However, all those bad debts and unpaid loans are still there. There is no easy way out of this mess. It would be better to face up to the problems we now face.
Higher interest rates will discourage consumption, people will again have an incentive to save, and house prices will return to more reasonable levels. Lower consumption will probably result in a slowdown in growth. The banks need some time to work off all those bad loans. It will be a difficult time. However, if the Bank of England recklessly cuts rates, it will only delay the moment of truth. All our problems will will grow, and we won't avoid the need for adjustment.