Economic View: Cutting edge could go blunt

We must not kid ourselves that cheap money is a magic solution to weak demand, nor that it is cost-free

The general verdict on the Bank of England's cut in interest rates last week was that it was an insurance policy against a sharper-than-expected slowing of the economy. That sterling had risen a wee bit in the last month or so gave both the impetus and the excuse for such a move. And it showed the willingness of the Bank to cut rates to try and keep the economy growing.

The markets are divided on whether there are more reductions in store. A straw poll of City institutions indicated that this may be the bottom. But a check on money market rates, which show what, in theory, rates should be in a year's time, suggest a further fall to 3 per cent (see first graph).

That the Bank is concerned about economic growth is the conventional explanation for the cut, and that is fine as far as it goes. But there seems to me to be something much bigger happening here. This is the test of whether monetary policy works and what, if it does, are the costs incurred?

You see, we have no post-war experience of the use of monetary policy to boost demand at a time of very low inflation. You have to go back to the 1930s to have that and the 1930s were (fortunately) a very odd period. Then there was an international trade war, huge unemployment and spare capacity, and a sustained depression in the US and parts of Europe.

In shorthand, very low rates did work here in parts of Britain for they stimulated a housing boom. But the effect was more marked in the South-east and was much more muted in the North and in Scotland. In the US and much of continental Europe, low rates barely worked when eventually they were tried. Britain staged a more rapid recovery from the recession than any other developed nation, with the partial exception of Nazi Germany.

The 1950s provide a poor parallel too. We now have interest rates and inflation at 1950s levels, but in other respects the circumstances are very different. There was still, in the UK at least, a hangover of frustrated demand. Living standards were gradually recovering and people were getting their first cars and TVs - and, for many, their first owner-occupied homes. So whenever rates were cut, people rushed out to buy things. But that was under the Bretton Woods fixed exchange rate regime. The overriding economic problem was that when consumers splashed out, imports shot up and there was a run on the pound. So interest rates had to be put back up to get the pound into line.

There was so much pent-up demand that the main task of monetary policy was to hold it back; every time the brakes were eased it would zip away. Some of that spirit lingers. We have hugely increased our household debts since 1997 (second graph) as rates have fallen. But there must come a time when they cannot fall much further, and we must be approaching that time.

Indeed, only now are we confronting the possibility that cutting rates still further might not continue to boost demand here in Britain. We know it has not worked in Japan, but then we comfort ourselves by saying that there are special circumstances there, such as bankrupt banks.

Low rates do not seem to be working in Germany, largely because the European Central Bank has to set rates for the entire eurozone. But even allowing for that, the German situation is alarming: it is a pretty rum world where 2 per cent interest does not boost an economy.

And finally in the US, money that is actually free, after allowing for inflation, has only enabled the most sluggish recovery from any recession since the Second World War.

Indeed, to find a parallel to the present conjunction of falling goods prices (the retail price index is only rising because it is pulled up by higher prices for services), potentially slack demand and very low rates, you have to go back to the 19th century. Again, other economic conditions were utterly different from today. So we have embarked on a journey without maps.

My guess is that the interest rate weapon will continue to work to a certain extent, but it will work progressively less effectively. We will be more like the US and less like Japan and Germany. If the housing market tanks despite such low rates, then that guess might prove over-optimistic. But intuitively it makes sense, given the historic willingness of Britons to borrow, particularly for housing.

But there will be costs. Some will be social. We are denying savers a decent return on their money, in effect transferring money from the old to the young. We may also be pushing some savers into unwise investments in their hunt for higher returns.

Other costs will be economic. Of course there is the danger of recreating inflation, but that is some way off. I am more worried about long-term interest rates.

The initial effect of rate cuts at the short end is to pull down long-term ones too. That is how banks make much of their money - by borrowing short and lending long. At some stage, people may start to feel that short-term rates will have to rise or that long-term ones have reached unsustainable lows. Then they start to climb.

There is some evidence of that in recent weeks in the US. Long-term rates for governments may not have risen much yet, but rates for companies are quite high. This is one of the reasons the US recovery is so sluggish. A rise in long-term rates is a warning signal that cuts in short-term ones have become ineffective. The central bank cuts rates, sure, but in practical terms many borrowers find that the cost of servicing their debt starts to rise, not fall.

So a qualified welcome to this reduction in rates. It is probably safer to move now than to wait, as the European Central Bank chose to do. But we must not kid ourselves that cheap money is a magic solution to weak demand. Nor should we think that cheap money is cost-free.