As is obvious when you read it it, Bootle wrote this before Mandelson and Brown announced that they don’t give a damn what everybody thinks, they’re going to carry on borrowing and spending.
But read here what will happen if they do! Perhaps Mandelson thinks that that’s when the EU makes its killing.
Christina Speight
TELEGRAPH
29.6.09
We can afford to keep interest rates at record low for many years
Slack in the economy will be keep price pressures well contained, without the need for higher rates, says Roger Bootle.
The economy has been in such a weak and dangerous situation that it has required an extraordinary policy response from the authorities. It has got it. There are three exceptional policy stimuli in place, namely record low interest rates, quantitative easing and extremely loose fiscal policy. And at some point, they will all need to be reversed. But when? And in what order?
Markets have already turned their attention to when official interest rates might rise from the current 0.5pc. They expect a reasonably sharp rise, with Bank Rate reaching around 2.5pc by the end of next year. There are no financial instruments to tell us what the markets think about when quantitative easing (QE) or the huge fiscal loosening will be reversed. But it seems fair to assume that markets think that interest rate rises could come fairly early on in the process.
On the face of it, there are some good reasons to think that they are right. Low interest rates were surely a leading cause of the asset bubble whose bursting got us into the present mess. Alan Greenspan, former chairman of the US Federal Reserve, has been heavily criticised for keeping interest rates in the US too low for too long, and thereby fuelling the bubble. The ultra-low levels of interest rates also prompted a search for yield by financial institutions, prompting them to pile into all sorts of dodgy assets.
Similar arguments have been made here. During the period of low UK interest rates after the dotcom bust at the start of this decade, house prices rose by some 70pc. The Monetary Policy Committee has been criticised, in particular, for cutting interest rates in August 2005 and thus apparently reigniting the housing boom. Given all this, the Bank of England will understandably be anxious not to make the same mistake again by keeping interest rates low for too long. And there's no doubt that once the economy is looking healthy again, interest rates will need to return to more normal levels.
But does that necessarily mean that markets are right to expect interest rates to start rising again within the next few months? I don't think so. For a start, it will be a long time before the large amount of spare capacity that is building during this recession is used up. And until it is, the slack in the economy will be keeping price pressures well contained, without the need for higher interest rates. Even if the economy recovers strongly, it could take years for this spare capacity to be eliminated. And all the signs are that the economy will not be recovering strongly.
In any case, I suspect that there will be more than enough policy tightening coming from the fiscal side. [That’s not what the ‘eejits’ are saying today. It’s still full speed ahead and to hell with the consequences -cs] The public finances are in a truly appalling state, with Government borrowing running at the highest ever peacetime level. Under the current plans, gargantuan public borrowing persists for so long that the ratio of public sector net debt to GDP will not fall back below the 40pc ceiling previously specified by the now abandoned fiscal rules until around 2035. The markets will not stand this extended period of bloated borrowing without forcing up the rate at which the Government borrows – which will make the position worse. If the Government is not careful, it could end up in a debt trap – where it is effectively forced into a default. [That’s the crucial point! -cs]
In other words, the top priority is to tighten fiscal policy. The Government will come under increasing pressure to sort out this mess – as highlighted by comments by the Bank of England Governor last Wednesday. "The scale of the deficit is truly extraordinary," Mr King said. "There will certainly need to be a plan for the lifetime of the next parliament, contingent on the state of the economy, to show how those deficits will be brought down." He is right. And once the election is out of the way it will surely happen. [That’s a year off and can we stand a year of things getting worse by the day? -cs]
One way or another, via higher taxes, sharp cuts in spending or a combination of the two, borrowing will be forced lower. I have repeatedly argued that cuts in spending should bear the brunt. [That’s what everyone agrees - the public, the economists - all of them except this dysfunctionmal non-government -cs] But whichever way they do it, fiscal tightening will deal a blow to the economic recovery.
Total government spending (both current spending and investment) accounts for around one third of GDP. Accordingly, even real cuts of 2pc per annum would knock around 0.7pc off annual GDP growth, which, even without the fiscal tightening, was probably set to be next to nothing anyway.
Even when the Monetary Policy Committee does feel the need to tighten monetary policy, I think that reversing QE, not raising interest rates, should be first in line. After all, it is the most unorthodox, the least well-understood and the most dangerous element of the current extreme policy response. Policymakers have managed to avoid a mass panic about a Zimbabwe-style printing of money. But they will still be keen to dispel fears that the vast amounts of money sloshing around the economy will prompt inflation to surge. I also suspect that they aren't particularly comfortable with the policy themselves.
Keeping interest rates low would have the added benefit of helping to keep the exchange rate down – thus improving the chances of a net export-driven recovery – and putting downward pressure on bond yields, thus minimising the cost of financing the mountain of Government debt.
If we are facing a whole parliament of tightening fiscal policy, then I think we should also be contemplating the same period of near-zero interest rates. After all, if fiscal tightening is imposed upon a weak economy then not only will the economy turn out even weaker, but the tightening will be at least partially offset by the effect of lower tax revenues. The way to make sure that the fiscal tightening actually brings the deficit down quickly is to make sure that it is accompanied, as far as possible, by economic growth. The banking system is going to be short of capital, risk averse and hemmed in by controls and regulations. Meanwhile, consumers and businesses are not going to be minded to increase their spending very readily. So the economy will need all the help it can get.
The last time we found ourselves in a similar position, in the 1930s, interest rates were kept at their then record low of 2pc for pretty much two decades – from 1932 to 1951, with a brief flurry in 1939 for reasons you can guess. Even I wouldn't go so far as to suggest a repeat of that. But I do think that interest rates could be kept at their record lows for as long as five years. That is a prospect to get the markets thinking.
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Roger Bootle is managing director of Capital Economics and economic adviser to Deloitte.
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