Monday, 20 October 2008

Interest rate cuts are not the answer

I love Anatole Kaletsky's column in the Times. It is either one extreme or the other.

A few weeks ago, he assured everyone that the credit crunch and sub prime defaults were a passing phase. The US was about to bounce back fast. As for a recession, there was little chance of a serious slowdown.

Now, he has swung in the other direction. His latest offering is full of apocalyptic language warning us of catastrophe if the government doesn't do something. Here are a few sentences that give a flavour of the new Kaletsky:

"As a result of the global banking meltdown that began in the second week of September, the world economy has plunged into recession."

"A catastrophic collapse is a real threat."

"All that matters today is preventing an outright collapse of the non-financial economy that would match the scale of the financial disaster."

Anatole has a few ideas how we can avoid doomsday. Rates need to come down sharply. "A full-point cut at the next MPC meeting followed by another half-point in December would get rates down to 3 per cent by Christmas. "

There are at least four problems with this advice. First, monetary conditions are very loose at the moment. The UK money supply is growing at double digit rates. Besides, Anatole would do well to re-examine the UK experience of the 1970s when rapid monetary growth and low interest rates did nothing to increase growth and keep unemployment down.

Second, the Bank of England's policy rates are now solidly negative. As economic distortions go, there are few worse than negative interest rates. It distorts savings and investment decisions, leads to capital flight and increases inflationary expectations. No economy can thrive with such distorted price signals.

Third, it is true, however, that while the Bank of England have cut their rates, the interest rates that firms and households face have not come down. This is because the monetary transmission mechanism isn't working properly. If the bank cut rates to 3 percent as Anatole suggests, it wouldn't be passed onto the real sector. This is because we have a banking crisis and until the banks return to viability, rate cuts won't work as Anatole envisages.

Finally, inflation is at a 16 year high. Furthermore, as the credit crunch has progressed and economic growth has slowed, inflation has risen sharply. These are nasty facts that Anatole can not ignore. He might think that there is a trade off between inflation and growth, history tells us otherwise.

Unfortunately, the UK economy is throwing up problems that do not make sense for Anatole. We are drifting into a recession, but inflation is picking up. We have a credit crunch, but monetary growth is rising at double digit rates. The MPC has cut base rates, but the economy doesn't respond. It has left poor Anatole confused, and in his distressed state, he thinks more easy money is the answer.

Debt is the starting point for understanding the true nature of the problems facing the UK right now. Households and the government are drowning in debt, while banks are horribly exposed increasingly distressed borrowers. Debt is directly responsible for our banking crisis, it is also responsible for pushing us into recession. The debt crisis has pushed the BoE to cut their rates in the vain hope to relieve the stress on increasingly insolvent borrowers. Debt, along with negative interest rates, are destabilising inflationary expectations, prompting firms to increase their prices.

If Anatole thinks that there can be a debt financed pick up in economic growth, then he hasn't learnt anything in the last 18 months.

10 comments:

Anonymous said...

Kaletsky is a fool.

dearieme said...

I think you'll find that he hasn't learnt anything in the last 18 years.

Stevie b. said...

Kaletsky said a falling Pound would really help the country cos of exports. I tried to ask "what exports and to whom", but the Times didn't print it. I had a lot of respect for him must've been 20 years ago. But he's really gone off the rails of late.

sobers said...

Rule 1: Never listen to Kaletsky. He hasn't got a clue.
Rule 2: See rule 1.

Nick von Mises said...

Anatole is a clown.

Anonymous said...

I was shocked by the turnaround - one day he was happy, the next he was sad.

seema said...

Anatole is stuck in a 1960s timewarp.

Mark Wadsworth said...

What Dearieme says.

I can see a window of opportunity for a bold, incoming government: instead of a temporary surge in public spending to 'kickstart the economy' (which a) won't work and b) is likely to become permanent), how about a 'temporary' cut in taxes - announce a one-year holiday from Employer's National Insurance and VAT* for example - and 'temporary' one-year sabbaticals on no pay for millions of quangista, and see what happens?

And if it works, just keep extending it by a year until nobody can evisage going back to the old ways.

* If the EU kick us out, so much the better. They are so busy infighting they might not even notice.

Steve said...

As you say: debt is the problem.

I heard elsewhere that: money is debt.

Therefore: money is the problem.

I am not certain because I am not an economist but it looks like our monetary system is the root of the problem. Money itself is the problem.

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