Umm, Simon?

Many financial experts – the same people who either got us into the present hideous mess or who failed to see it coming – are either confidently predicting or demanding a cut in interest rates by the Bank of England next week. Ignoring the wise words of a former Labour prime minister – Jim Callaghan – that you can\’t spend your way out of a recession, that is precisely what these geniuses say we should do to get the economy going.

This is mad on so many counts I don\’t know where to start. Since high interest rates didn\’t cause this mess, why should lower ones get us out of it? If banks won\’t lend to other banks, why will giving them a lower rate of return for doing so make them more disposed to lend? Since this mess was caused by too much money in circulation, why make it worse – and drive up inflation – by putting a lot more out there? If the Bank cuts rates, it would be for political not economic reasons, and its so-called independence would be proved to be a joke.

The argument is that we\’re trying to do something a little different from sorting out the banks. We\’re trying to make sure that there is no general freezing up of credit creation (ie, we don\’t want the money supply to actually fall). For we\’re pretty sure that a falling money supply brings with it general deflation and thus a depression, rather than the recession we\’re already likely to get.

This may or may not be a correct argument (it\’s one I ascribe to but so what?) but that is what it is.

You\’ve also slightly missed the point about interest rates. Banks care very little for the absolute level of rates, that\’s not where their profits come from. They come from the difference between base rates and the rates at which they lend. If we lower base rates and even if their lending rates stay just where they are then their profits will increase….as will their incentives to lend money, just what we want them to be doing.

That easy availability of money was one of the things that led to the bubble might be true: but we really really do not want to see the impact upon an economy of no or little credit creation. Not again, anyway, as 1930\’s US and 1990\’s Japan should be quite enough to scare the bejabbers out of anyone.

BTW, did you know that the UK did a great deal better in the Depression than the US did? We came off the gold standard, which in hte system of the day was equivalent to loosening the monetary stance, and the worst of our slump was over 18 months later. The US tried all sorts of other things but their problems grumbled on until 1939…..

2 thoughts on “Umm, Simon?”

  1. The reason “the UK did a great deal better in the Depression than the US did” is we didn’t enjoy the boom in the 1920s. After WW1 we tried to return to the gold standard at a rate which crippled our economy. No boom so no bust.
    (It is also a myth that the US didn’t try to inflate their economy in 1930s – I hate to say this but Milton Friedman was wrong about that.)

  2. Sir S is spot on.

    And even if you are correct that ‘we’ are worried about ‘credit creation’, cutting interest rates is no solution. (the two points of view are not direct opposites anyway).

    If the BoE decided that its base rate is henceforth going to be nil, would people be prepared to lend to UK banks at no interest? Nope. They will continue to demand the same rates of interest as before because it is the creditworthiness of banks that is the problem here.

    Hence fix that first. By doing proper and honest write downs of dodgy mortgage assets and by doing debt-for-equity-swaps (forcibly if necessary) to recapitalise banks.

    Having re-established trust between banks and investors, banks will then have more money to on-lend to businesses.

    BTW, net mortgage lending is now flat or negative, there is NO NEED for more credit to go into housing market as the bubble is deflating. So banks can take net repayments from mortgage borrowers and on-lend them to the productive economy.

    Here endeth.

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