What is to be done? As a result of the global banking meltdown that began in
the second week of September, the world economy has plunged into recession.
Whether or not this mishap could have been avoided if the US Government had
taken timely action to stabilise Lehman Brothers instead of deliberately
driving it into bankruptcy is a moot point. All that matters today is
preventing an outright collapse of the non-financial economy that would
match the scale of the financial disaster.
Such a catastrophic collapse is a real threat. Only a handful of economic
statistics relating to the post-Lehman period have been published so far,
but they show record-breaking falls in consumer spending, industrial output
and housing — and anecdotal evidence suggests that much worse is to come.
One typical comment: “The real collapse has not even started because banks
were waiting to be recapitalised before they put their overleveraged
borrowers into liquidation. There will be a tsunami of commercial properties
foreclosures and private equity bankruptcies in the first quarter of next
year.”
So is it now too late to prevent the chaos that suddenly engulfed the
financial system this month spreading to rest of the economy? Probably not,
but radical action is extremely urgent. The main mechanism to protect
non-financial jobs, investment and consumption must, as always, be
macroeconomic demand management. But before focusing on macro policies, let
us not forget that this disaster started in the banking system and that much
of the damage was done by ill-considered accounting and regulatory changes
driven by the fundamentalist ideology that “the market is always right”.
Specifically, policymakers around the world should suspend the
mark-to-market accounting and “risk-based” capital regulation that has
vastly exaggerated the boom and the bust of the present credit cycle and has
magnified a normal, if severe, downturn in global property markets into the
greatest financial crisis of our lifetimes. The British Government should
also be ready to renegotiate some of the details of its broadly sensible
bank rescue package — for example, by tightening the requirement to maintain
credit lines and also by eliminating the five-year minimum term of the
preference shares - in order to increase the chances that private
shareholders will help to recapitalise the banks.
Turning to the core macro issues, the top priority in Britain and the rest of
Europe, particularly, must be sharply lower interest rates, rather than the
fiscal stimulus suggested by Alistair Darling over the weekend. This is for
four reasons. First, there is huge scope for lower interest rates in Britain
and the eurozone. This is not true of the United States and Japan, where
interest rates are already near rock-bottom levels and fiscal stimulus is
likely to be the main defence against recession. Secondly, fiscal packages
take months to implement and are liable to be politically captured by
special interests. Thirdly, public borrowing has to be repaid, meaning that
large fiscal packages should be complemented with credible long-term plans
to reduce spending or increase taxes. While a newly elected US president
might be able to propose a radical restructuring of the tax system that
would stimulate the economy in the short term while reducing deficits in the
long term, it will be impossible to strike such a balance in Britain a year
before the general election.
Finally, and most importantly, experience suggests that monetary policy is
generally more effective than fiscal policy in managing demand. This is
likely to be true even though the credit system is paralysed, partly because
lower official rates are needed to compensate for drastically wider credit
spreads and partly because ultra-low official rates will help to strengthen
the banks and encourage them to resume lending.
How far, then, should interest rates be reduced? In the past two British
recessions — 1979-82 and 1991-92 — interest rates were cut by a
whopping ten percentage points before growth was restored . Looking back to
the 1960s and 1970s, interest rates reductions in recessions were never less
than three percentage points. Thus the minimum action required from the Bank
of England is a three-point cut from the peak of 5.75 per cent to 2.75 per
cent. But, given the magnitude of this crisis, the Bank should be much
bolder.
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. Beyond that, the
Bank and the Government should make clear to the public and business
community that Britain is moving towards rates much lower than anything
experienced since the Second World War. Policymakers must focus on a simple
and undeniable fact: Britain is more exposed than any other major economy to
a housing slump and a contraction in financial services. Britain should,
therefore, have the lowest interest rates — not the highest — in the world.
This implies that the Bank's objective should be to get interest rates down
to 2 per cent by the spring and to around the US level — 1.5 per cent at
present but almost certain to be reduced to 1per cent before the end of this
year.
An interest rate of 1 per cent may be far outside the experience of anyone
living in Britain today, but then the same is true of the banking crisis.
Gordon Brown was the first to recognise that these unprecedented events
demanded unprecedented responses and this is as true of monetary policy as
it is of government support for banks. It follows, therefore, that Britain
should adopt the ultra-low interest rate regime that is taken for granted in
the US and Japan. And the Japanese experience of the 1990s shows that
central bankers must be prepared to “think the unthinkable” about interest
rates sooner rather than later, if they want to avert disaster.
The British Government, having unexpectedly emerged as global leader in the
institutional response to the banking crisis, should take the lead in a
monetary policy gestalt-shift - and right away. A consequence of Britain
reducing interest rates to well below the European level may well be a sharp
fall in sterling. The possibility of a large temporary currency movement,
far from deterring such a radical shift in monetary policy, should be seen
as desirable. In a flexible market economy, exports act as a natural offset
to the slump in financial services and housing — this is what is happening
in the US. The ability to use radically lower interest and exchange rates to
stabilise the British economy is the main advantage of keeping sterling out
of the euro.
Now is the time for the Bank of England to take maximum advantage of this
freedom of action. If the Bank fails to do this, then critical mutterings
about its erratic performance in this crisis will turn into a full-blown
challenge to central bank independence from politicians of all parties. And
if the Bank refuses to act urgently to mitigate the recession, a challenge
to its independence will be amply justified.
